Tax Consequences of Severance Pay

When an employee quits their work, whether willingly or as a result of termination or layoff, they may seek to make ends meet by collecting severance money. Some people, however, are unsure if severance pay is taxed while many barely know the tax consequences of severance pay at all. 

What Is Severance Pay

Severance pay is compensation that many employers provide to workers following an involuntary termination, such as a layoff. Typically, it is computed based on the duration of your employment with the terminating firm. Employers are not required to provide severance money to departed employees, although many do. At the time of termination, the employer and employee discuss severance pay.

When the majority of people think about severance pay, they envision enormous payouts handed to company CEOs when they are forced to resign. Regular workers, however, frequently get severance compensation upon termination of employment. Severance compensation, however, is not a federal obligation under the Fair Labor Standards Act (FLSA)

Agreements for severance compensation are solely between an employee and their company.

How Much is Severance Pay?

Severance compensation is frequently computed using the employee’s salary and length of service. If you work for a firm for five years and they give two weeks’ salary for each year of employment, you may be paid ten weeks’ earnings.

As part of a severance package, employers frequently extend health insurance coverage for a short amount of time. Employer and employee agree on the ultimate severance value.

How Is Severance Pay Taxed?

Most people do not know how severance pay is taxed, therefore, it is necessary to shed some light on that. It is unfortunate to note that severance pay is taxed. In general, both employees and employers are responsible for paying a 6.2 percent Social Security tax and a 1.45 percent Medicare tax on an individual’s salary. 

These are referred to as FICA taxes, payroll taxes, or employment taxes.

Severance pay, on the other hand, is often paid after you have completed your employment with the business. As a result, some individuals assume they are not obligated to pay FICA taxes. This, however, is incorrect. The Supreme Court of the United States has determined that severance payments are, in fact, regular earnings subject to regular payroll taxes.

Additionally, severance payments are considered as “supplemental earnings” and so subject to their own tax implications. Employers are obligated to deduct 22% of severance compensation and remit the funds to the IRS. State income taxes will also be deducted from severance payouts in 43 states.

What Does It Mean To Employees

Knowing that severance compensation is taxed is critical information for employees who anticipate receiving layoff payments. Employees frequently have the option of negotiating a severance compensation package. Because they are aware they would be taxed, an employee may negotiate a bigger severance payout with their soon-to-be departed employer.

Are Unemployment Benefits Taxed Too?

Numerous employees obtain unemployment compensation following a job termination. While it may appear to be outrageously unjust, unemployment benefits are also taxed. Unemployment assistance beneficiaries in California are required to pay FICA taxes. Unemployment payments, on the other hand, are exempt from California state income taxes.

What About Wages That Have Not Been Paid?

Employees who are terminated or who resign are often entitled to receive their final payment immediately or within 72 hours of termination, depending on the circumstances. Employers who fail to pay an employee’s last paycheck on time may be subject to extra monetary penalties for each day late. Due to the fact that these salaries are considered part of a worker’s normal income, both federal and state taxes must be withheld.

What Can You Do?

If you have been laid off or anticipate being laid off soon, you may be able to negotiate a severance compensation plan. It is prudent to seek the assistance of an employment law attorney in these instances. Your attorney may be able to assist you in negotiating a more favorable layoff package and may advise you on the tax implications of your final payments.

How You Can Minimize Taxes on Your Severance Pay

While being laid off is never a pleasant experience, it may be beneficial to your savings account if you receive a severance payment. It may enable you to pursue training while looking for work, supplement your emergency fund, or pay off debt. However, many people overlook the fact that they will be required to pay taxes on their severance. Fortunately, there are various methods to reduce one’s tax burden.

Contribute to A Retirement Account

Contributing to a tax-deferred account, such as an individual retirement account, is a simple method to pay less tax on severance money. For the tax years 2021 and 2022, the contribution ceiling is $6,000. If you are over 50, you may contribute an extra $1,000 as a catch-up payment.

Financial gurus advise you to save as much as possible. It is recommended that you give the highest amount possible if the chance presents itself.

Certain companies may even permit you to contribute your severance money to your 401(k). The maximum for 2022 is $20,500 (the limit for 2021 is $19,500). If you’re over 50, you may save an extra $6,500.

Time Your Payout

A simple strategy to pay less tax is to get your severance pay in two distinct years. Inquire whether the payments may be spaced out to prevent a large tax burden in a single year. For certain people, taking a lump payment may result in an unanticipated tax bill.

Receiving a single substantial lump-sum payment may result in you being taxed at a higher rate which might result in significant adjustments on the amount you owe

Open a 529 Plan

If you have children or wish to contribute to the college tuition of a young niece or nephew, consider investing your severance money in a 529 plan. You may even qualify for state tax deductions as a result of your contribution. 

Please carefully read the regulations to ensure that your contribution does not qualify as a gift. You don’t want to add to your own headaches while attempting to reduce your tax liability.

Additionally, under the SECURE Act of 2019, you can utilize a 529 to repay up to $10,000 of your own student loan debt.

It may make sense to join a 529 plan, take advantage of any applicable state tax advantages, and quickly repay student debts.

Make Investments in a Donor-Advised Fund

A donor-advised fund is a one-of-a-kind option to offset the taxes on your payment while also benefiting your chosen charity. The finest feature of a donor-advised fund is that it enables a person to earn a tax advantage while exercising control over how an organization receives funds. 

These accounts, which are sponsored by national charity organizations, keep your donations and allow them to grow in anticipation of future payouts or awards.

The Bottom Line

The tax consequences of severance pay are crucial to understand for terminated employees. When you learn you’re receiving a payout and are unsure what to do next, consult a specialist. A certified public accountant (CPA), certified financial planner (CFP), or other financial expert can offer you advice on how to manage your money, even if you believe you know best.