How Is Severance Pay Taxed?

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Severance payments enable many out-of-work professionals to bolster their savings while they look for new jobs, go back to school, or invest in professional development. It is important to note, however, that severance pay is taxable, and recipients are required to report those earnings when they file their taxes.

What Is Severance Pay?

Severance pay, as the name implies, is payment that many companies remit to their employees upon involuntary termination like a layoff. Typically, severance pay is calculated based on the length of time the employee has worked for the terminating organization. While employers are under no obligation to grant severance pay to terminated employees, many choose to do so. Severance pay is negotiated between the employer and employee (or the employee’s representative) at the time of termination.

Is Severance Pay Taxable?

Severance pay, along with unemployment compensation and payments for accumulated vacation and sick time, is taxable in the year of payment, just as any other form of payment would be. Luckily, employers simplify the tax payment process by including the amount in the Form W-2 and withholding the appropriate federal and state taxes.

Typically, the following amounts are 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)
  • State income withholding tax (varies by state and tax bracket)
  • 6% Federal Unemployment Tax (FUTA) paid by the employer on the first $7,000

How to Minimize Taxes on Your Severance Pay

Thankfully, several options exist for people hoping to minimize their severance pay tax bill. The following are some of the financial strategies you can use to maximize your savings:

Put It 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 expenses. HSAs are pretax accounts that can be used toward health or medical needs. The 2021 HSA contribution limit stands at $3,600 for individuals and $7,200 for families.

Save for Retirement

You might also want to consider contributing to an individual retirement account (IRA). Individuals can contribute up to $6,000 a year to an IRA, which is not taxed until it is withdrawn upon retirement. Alternatively, you can deposit funds into a Roth IRA, which is taxed upon deposit but not upon withdrawal. Either way, IRAs can help reduce your federal tax payments.

You may even be able to contribute to your employer’s 401(k) plan, which has an annual limit of $19,500 plus an additional $6,500 for individuals over 50 years old.

Spread Out Your Payments

Consider negotiating a staggered 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. Staggering payments also can lower your tax bracket and ultimate tax rate.

Help Pay for an Education

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

Frequently Asked Questions (FAQs)

How Much Is Severance Pay?

That depends. Your employer is not required to offer a severance package upon your termination. Many employers choose to offer severance pay anyway, particularly when termination is due to a layoff or when the reason for separation is not based on misconduct. Severance is often calculated as a function of salary and time spent at the company. For example, if you have worked for a company for five years and they offer two weeks of pay for every year of employment, you will be paid 10 weeks’ wages.

Often, employers include health insurance benefits for a limited amount of time as part of a severance package. The ultimate severance value is agreed upon between the employer and employee.

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 a layoff, although it is also common for employees to receive payment when their separation is the result of performance. 

It is unusual for companies to pay severance to employees who were terminated “for cause,” or conduct reasons. Frequently, employers will require the terminated employee to sign a separation agreement in exchange for the severance pay. 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?

That depends on the state because individual states administer unemployment benefits and they each have a unique set of rules. “It is 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. Bear in mind that if your state of employment differs from your state of residence, you may have to check with both states.