How Is Severance Pay Taxed?

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Severance payments can help many out-of-work professionals bolster their savings while they look for new jobs, go back to school, or invest in professional development. But severance pay is taxable, and recipients are required to report these earnings to the IRS when they file their tax returns.

What Is Severance Pay?

Severance pay is money that many companies remit to their employees upon involuntary termination, such as a layoff. It's typically calculated based on the length of time you worked for the terminating organization. Employers are under no obligation to grant severance pay to terminated employees, but many choose to do so. Severance pay is negotiated between the employer and the employee at the time of termination.

Is Severance Pay Taxable?

Severance pay is taxable in the year of payment, along with any unemployment compensation you receive and payments for accumulated vacation and sick time. Employers usually simplify the tax payment process by including the amount on your Form W-2 and withholding the appropriate federal and state taxes. These taxes are typically withheld from severance payments:

  • 12.4% Social Security tax (6.2% each from the employer and the employee)
  • 2.9% Medicare tax (1.45% each from the employer and the employee)
  • Federal income tax withholding (varies by your tax bracket and filing status)
  • State income withholding tax (varies by state, tax bracket, and filing status)
  • 6% federal unemployment tax (FUTA) paid by the employer on the first $7,000

The Social Security tax has a wage base limit of $147,000 a year as of 2022. Income over this amount in a given year isn't subject to the tax. The wage base limit can increase periodically to keep up with inflation.

A 0.9% Additional Medicare Tax applies to wages that exceed $200,000 for single taxpayers, or $250,000 for those who are married and filing a joint return. There's no ceiling on wages subject to the Medicare tax.

How to Minimize Taxes on Your Severance Pay

Several options exist if you're hoping to minimize your severance pay tax bill.

Put the Money in Your HSA

Contributing to a health savings account (HSA) is a great way to both minimize your tax burden and save for future health and medical expenses. HSAs are pre-tax accounts that can be used toward health or medical needs. The 2022 HSA contribution limit stands at $3,650 for individuals and $7,300 for families.

Save for Retirement

You might also want to consider contributing to an individual retirement account (IRA). You can contribute up to $6,000 a year to an IRA as of 2022, or up to $7,000 each year if you're age 50 or older, and this money isn't taxed until it's withdrawn in retirement. You can also contribute funds to a Roth IRA, which is taxed when you deposit the money but not upon withdrawal. IRAs can help reduce your federal tax payments either way.

You may even be able to contribute to your employer’s 401(k) plan, which has an annual limit of $19,500 in 2021, plus an additional $6,500 for individuals over 50 years old. This limit increases to $20,500 in 2022, although the extra $6,500 boost remains the same.

Spread Out Your Payments

Consider negotiating a staggered severance payment with your employer. Spreading a severance package out over two or more years can help ease the burden of having to pay a single large tax liability.

Staggered payments also can lower your tax bracket and corresponding tax rate.

Help Pay for Education

Some recipients of severance pay choose to put the money into a 529 plan. These plans are tax-advantaged savings vehicles that are typically used by parents to save for their children’s educations. Rules for these plans vary by state, but the earnings aren't subject to federal and state income taxes (although the contributions are). The funds can be used to cover the costs of kindergarten through higher education.

Frequently Asked Questions (FAQs)

How Much Is Severance Pay?

Severance pay is often calculated as a function of salary and time spent at the company. You might be paid 10 weeks’ wages if you worked for a company for five years and they offer two weeks of pay for every year of employment. Employers often continue health insurance benefits for a limited period of time as part of a severance package. The ultimate severance value is agreed upon between the employer and employee. Separating employees are also entitled to continue health insurance coverage through their employer's plan at their own expense for a limited period.

Who Gets Severance Pay?

Employees receive severance pay from their employers if the terminating employer decides to offer a severance package. Employers most frequently offer severance pay in layoff situations. It's unusual for companies to pay severance to employees who were terminated “for cause” or for conduct reasons. Employers will frequently require the terminated employee to sign a separation agreement in exchange for the severance pay when they do pay it. These agreements often bar the separated employee from speaking negatively about the company, divulging confidential information, or accepting a job with a competitor.

How Does Severance Pay Affect Unemployment?

The effect of severance pay on unemployment depends on the state. Individual states administer unemployment benefits, and they each have their own unique sets of rules.

“It's crucial to examine your state’s unemployment policies as they relate to severance,” Robert Premselaar, senior manager of tax and audits at Mach & Associates in New Jersey, told The Balance by phone. “In some states, like Texas and New York, unemployment benefits can be lessened or delayed by the receipt of severance benefits.” 

Check with your state’s unemployment office to determine its policy. You may have to check with two states if your state of employment differs from your state of residence. It may be a good idea to consult with an employment law expert to structure your severance agreement to enable you to maximize potential benefits in some situations.

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