Losing a job can be stressful, and severance pay is meant to ease that transition. However, many people are caught off guard by the taxes owed on their severance package. Understanding how severance pay tax works and planning ahead can help you reduce the tax burden and avoid surprises when tax season arrives.
Below, we’ll break down how severance pay is taxed, common tax scenarios, and strategies to minimize the impact on your finances.
What is Severance Pay Tax?
Severance pay is considered earned income, just like your regular wages. That means it is subject to federal and state taxes, as well as Social Security and Medicare taxes.
Here’s how it typically works:
- Federal Income Tax: The IRS requires employers to withhold 22% in federal income taxes on severance payments. If your severance is over $1 million, the withholding rate jumps to 37%.
- State Income Tax: If you live in a state with income tax, your severance pay will be subject to state withholding at your state’s tax rate.
- Social Security and Medicare Taxes (FICA): Just like wages, severance is subject to Social Security (6.2%) and Medicare (1.45%) taxes. If your total income exceeds a certain threshold, you may also owe an additional 0.9% in Medicare tax.
- Lump-Sum Payments vs. Installments: If you receive severance as a lump sum, it may push you into a higher tax bracket, increasing the overall amount you owe. Some employers offer installment payments to help spread out the tax impact.
Because severance pay is subject to automatic withholding, the actual tax you owe may be higher or lower depending on your total income for the year.
Common Severance Pay Tax Scenarios
The way severance pay is taxed can depend on several factors, including how it is paid, your other sources of income, and whether you qualify for deductions.
Here are some common scenarios:
- Lump-Sum Severance Pay: If you receive your severance all at once, it could push you into a higher tax bracket. This may result in a larger tax bill at the end of the year.
- Installment Payments: Some employers allow severance to be paid in installments over several months or years. This can help lower your tax bracket and reduce the amount owed in a single year.
- Severance and Unemployment Benefits: Some states reduce or eliminate unemployment benefits if you receive severance pay. Check your state’s rules to avoid unexpected reductions.
- Severance with Bonuses or Stock Options: If your severance package includes bonuses, stock options, or other benefits, those may be taxed differently. Certain benefits may be subject to additional withholding.
Understanding how severance pay fits into your overall financial picture is key to avoiding surprises.
Effective Strategies to Reduce Your Tax Burden
While severance pay is taxable, there are several strategies that may help reduce the amount you owe.
Here’s how you can lower your tax liability:
- Max Out Retirement Contributions: If your severance pay is taxable in the same year as your employment, consider contributing the maximum allowed to a 401(k) or IRA. This reduces your taxable income.
- Use a Health Savings Account (HSA): If you have a high-deductible health plan, contributing to an HSA can lower your taxable income while allowing you to save for medical expenses.
- Negotiate a Payment Schedule: If possible, ask your employer to pay your severance in installments rather than a lump sum. This could keep you in a lower tax bracket.
- Donate to Charity: Charitable donations can help reduce your taxable income. If you plan to make a significant donation, consider doing so in the year you receive severance.
- Adjust Your Withholding: If you expect a large tax bill due to severance pay, updating your W-4 form to withhold additional tax from your regular income may help you avoid an unexpected tax burden.
Planning ahead can make a big difference in how much tax you owe on severance pay.
Special Considerations for Severence Pay Tax
Every situation is unique, and there are additional factors that could impact the taxes on your severance pay:
- State-Specific Rules: Some states treat severance pay differently from regular wages, affecting tax rates and unemployment eligibility.
- Legal Settlements and Severance: If part of your severance package comes from a legal settlement, different tax rules may apply. Some settlements are tax-free, while others are fully taxable.
- Alternative Minimum Tax (AMT): High earners may be subject to the AMT, which could change how severance pay is taxed.
Because tax laws can be complex, consulting a tax professional is the best way to ensure you’re minimizing your liability.
How to Prepare for Severance Pay Taxes
If you know you’ll be receiving severance pay, taking proactive steps can help reduce the tax impact and keep your finances stable.
Here’s what you can do to prepare:
- Estimate Your Tax Liability: Use a tax calculator or consult a tax professional to estimate how much tax will be withheld from your severance. This can help you set aside funds if additional taxes are due.
- Review Your Budget: A severance package can provide temporary financial relief, but it’s important to plan for the months ahead. Adjust your budget to ensure you can cover necessary expenses.
- Understand Unemployment Rules: Check with your state’s unemployment office to see if receiving severance pay affects your ability to claim benefits. Some states delay or reduce unemployment payments if you receive severance.
- Consider a Tax-Advantaged Account: If you still have earned income, contributing to a tax-deferred account like a traditional IRA or HSA can lower your taxable income.
- Work With a Tax Professional: Tax laws are complex, and professional guidance can help you avoid costly mistakes while maximizing tax-saving opportunities.
Planning ahead can make severance pay a financial tool rather than a burden.
Tax Implications of Additional Benefits in Severance Packages
In addition to cash payments, severance packages often include extra benefits that can have tax consequences.
Here’s what to watch for:
- Health Insurance Coverage: Some employers offer continued health benefits, either by covering COBRA premiums or extending employer-sponsored coverage. While COBRA payments are not taxable, any employer-paid premiums may count as taxable income.
- Stock Options or Equity Compensation: If your severance package includes stock options or restricted stock, the tax treatment can vary. Some stock benefits are taxed when granted, while others are taxed when exercised or sold.
- Unused Vacation or Sick Pay: If your employer pays out unused vacation or sick leave, those payments are also subject to income and payroll taxes.
- Outplacement Services: Some severance agreements include career counseling or job placement services. These benefits are typically tax-free but should still be reviewed.
Understanding the full scope of your severance package can help you avoid unexpected tax liabilities.
What to Do If You Owe Severance Pay Tax
If you find yourself owing taxes on severance pay, don’t panic—there are ways to manage the situation.
Here’s how to handle a tax bill:
- Set Up a Payment Plan: If you can’t pay your tax bill in full, the IRS offers installment plans to spread payments over time.
- Adjust Future Withholdings: If severance pay has resulted in a tax shortfall, update your W-4 form to ensure the correct amount is withheld from future income.
- Use Savings or Emergency Funds: If possible, paying your tax bill in full can help you avoid penalties and interest charges.
- File for an Extension (If Needed): If you need more time to gather funds, filing an extension can give you extra time to pay without late filing penalties.
Understanding your options can help you manage your severance taxes without unnecessary stress.
Need Expert Severance Pay Tax Assistance?
Understanding how severance pay is taxed can help you make informed financial decisions and avoid unexpected tax bills. Since severance pay is considered earned income, proper tax planning is crucial to reducing your liability.
If you’re unsure about how your severance package will affect your taxes, working with an experienced CPA can help you develop a strategy that keeps more money in your pocket. Dimov Tax provides expert guidance to help you navigate the complexities of severance taxation and other financial matters.
Contact us today to learn more about your options.