Tax on Employment Termination Payment

When facing redundancy or resigning from a job, it’s crucial to understand the tax implications of employment termination payments (ETPs). While ETPs are considered taxable income, navigating their tax treatment can be intricate.

This article aims to provide insight into the taxation of ETPs in Australia and explore strategies to minimise your tax liability. By gaining a comprehensive understanding and seeking appropriate guidance, you can effectively manage the tax aspects of your ETP and make informed financial decisions when filing your tax returns in Australia.

What is Employment Termination Payment (ETP)?

An employment termination payment (ETP) refers to a payment made to an employee when their employment is terminated. ETPs are typically provided as compensation for the loss of employment and can include various components such as redundancy payments, severance payments, or other entitlements based on the circumstances of termination.

ETPs can encompass different types of payments, including lump sum payments, superannuation contributions, or other benefits. The specific components and amount of an ETP depend on factors such as the reason for termination, the employee’s length of service, and applicable employment laws or contractual agreements.

Not all employees are eligible to receive an ETP upon termination. Generally, an employee must have reached their preservation age (between 55 and 60, depending on birth date) or have met another specific condition of release to qualify for ETP.

Types of ETPs

Here are some common types of ETPs.

Redundancy Payments: These are payments made to employees who are made redundant due to job elimination, company restructuring, or other similar reasons. Redundancy payments are intended to compensate employees for the loss of their job and may include severance pay, notice pay, and any other entitlements due under employment contracts or labour laws.
Severance Payments: These are payments made to employees who voluntarily resign or retire after completing a long period of service with an organisation. Severance payments are often provided as an incentive to retain employees over the long term and may be based on factors such as years of service, salary, or a predetermined formula.
Notice Pay: This refers to the payment made to an employee when they are terminated without cause or given notice of termination. Notice pay is typically provided as compensation for the period between the termination date and the end of the notice period stipulated in the employment contract or labour laws.
Golden Handshakes/Golden Parachutes: These are substantial payments or benefits given to executives or high-ranking employees when they leave a company, often as part of a severance package. Golden handshakes or golden parachutes are usually negotiated as part of executive contracts and can include cash payments, stock options, bonuses, or other perks.
Retrenchment Payments: These payments are made to employees when their jobs become redundant due to business downsizing, closures, or technological changes. Retrenchment payments are similar to redundancy payments and aim to compensate employees for the loss of their job and provide financial support during the transition period.
Gratuity Payments: Gratuity is a lump sum payment made to employees as a token of appreciation for their long-term service. It is common in some countries, particularly in the Middle East, and is typically based on the employee’s length of service and final salary.

How ETPs are Taxed

In many countries, including Australia, employment termination payments are subject to specific tax treatment. In Australia, for example, the tax treatment of ETPs is governed by the Income Tax Assessment Act 1997. Here’s a general overview of how ETPs are taxed in Australia:

Tax-Free Component: The tax-free component of an ETP is determined based on various factors such as years of service, age, and the reason for termination. The tax-free component may include amounts such as genuine redundancy payments, certain early retirement scheme payments, or invalidity payments. The tax-free component is not subject to income tax.
Concessionally Taxed Component: The concessional taxed component of an ETP includes eligible termination payments that exceed the tax-free component. This component is subject to a lower tax rate than the individual’s marginal tax rate. The tax rate depends on the person’s age and the amount of the ETP, with a cap limit known as the “ETP cap.”
Excessive Component: If an ETP exceeds the ETP cap, the excess amount is considered the excessive component. The excessive component is taxed at the individual’s marginal tax rate, without the additional 15% tax.

It’s important to note that the tax treatment of employment termination payments can be complex, and there may be additional rules and considerations depending on the specific circumstances.

Taxation laws can also change, so it’s crucial to consult with a tax professional or refer to the relevant tax authority in your country for up-to-date and accurate information on how ETPs are taxed.

ETP Cap and Limitations

The Employment Termination Payment (ETP) is subject to specific caps and limitations, which can impact the tax treatment and overall payment received by the employee. It is crucial to understand these restrictions to avoid unexpected tax liabilities and ensure compliance with the law. Let’s delve deeper into the ETP cap and limitations.

ETP Cap Amount

The ETP cap amount refers to the maximum limit on the concessional tax treatment for ETPs. As of the current tax year, the ETP cap amount is set at $205,000. This means that any ETP payment that exceeds this cap will be subject to additional tax at the top marginal rate.

It’s important to note that the cap amount is not a fixed figure and may change from year to year due to legislative changes or adjustments to tax regulations. Therefore, it is essential to stay updated on the latest tax laws and consult with a qualified tax professional to determine the current ETP cap amount.

ETP Lifetime Limit

Apart from the annual ETP cap amount, there is also a lifetime ETP limit that individuals must be aware of. The lifetime limit is the total amount of ETPs an individual can receive without incurring adverse tax consequences. As of the current date, the lifetime ETP limit is set at $1.615 million.

Suppose an individual’s cumulative ETP payments exceed this lifetime limit. In that case, any additional ETP payments beyond this threshold will be treated as an “Excluded Termination Payment” (ETP) and taxed at the top marginal tax rate, along with an additional Medicare Levy.

It’s crucial for individuals who have received ETPs in the past or anticipate receiving them in the future to keep track of their cumulative ETP amounts to ensure they remain within the lifetime limit. Any breach of this limit can result in unexpected tax burdens, affecting the overall financial planning and tax strategies.

Considerations for ETP Cap and Limitations

Employers and employees alike should be aware of these ETP cap and limitations to avoid unintended tax consequences. Employers should ensure that ETP payments made to employees do not exceed the annual cap amount and are properly reported in payment summaries. Failure to do so may lead to tax penalties and compliance issues.

Employees receiving ETPs should be diligent in tracking their cumulative ETP amounts over their career. Proper record-keeping is essential to prevent exceeding the lifetime ETP limit. Seeking advice from a tax professional or financial advisor can help employees plan their ETPs effectively to minimise tax liabilities and optimise their overall financial situation.

How to Minimise Your Tax Liability

To minimise your tax liability on an ETP, consider these strategies:

Contribute to retirement accounts: Make concessional contributions to retirement accounts within the allowable limits to reduce your taxable income.
Utilise deductions and tax credits: Take advantage of available deductions and tax credits to lower your overall tax liability.
Time income and expenses: Consider deferring income or accelerating expenses to manage your tax liability effectively.
Manage capital gains and losses: Offset capital gains with capital losses to reduce your taxable income.
Seek professional advice: Consult with a tax professional or accountant for personalised guidance on minimising your tax liability.

Get Help from a Tax Expert

Employment termination payments can be a significant source of income, but they are also taxable. To navigate the complexities of taxation and maximise your ETP while minimising your tax liability, it is highly recommended to consult with an expert tax advisor. They can provide tailored advice based on your specific situation, jurisdiction, and applicable tax laws.

Reach out to a professional to receive personalised guidance and make informed decisions regarding your ETP.