Claiming A Severance Package: Is Severance Pay Taxable? How Does It Work?

Severance pay is what a business provides to an employee after a lay-off or retirement of the employee. It is different from unemployment compensation. Whatever the employee gets as severance pay, is liable for taxation by the IRS. You can also withhold some part of the tax amount that you pay to the IRS. However, based on how much you make, the tax bill can be higher or lower than the withheld amount.

In this article, you will learn about severance pay and the way severance pay is taxed. You will learn some of the essential details of the taxation process of severance pay as well. Furthermore, we will give you some useful tips with the help of which you can minimize your taxes on what you get from your employer as severance pay. Hence, to learn how the severance pay taxation process works, read on through to the end of the article.

What Is A Severance Pay?

As the United States Department of Labor puts it –

?Severance pay is often granted to employees upon termination of employment. It is usually based on the length of employment for which an employee is eligible upon termination. There is no requirement in the Fair Labor Standards Act (FLSA) for severance pay. Severance pay is a matter of agreement between an employer and an employee (or the employee’s representative).?

Hence, you can see from the quote that since severance payments are based on employment contracts and agreements between the employee and the employer, it is not compulsory. However, if the agreement says that the employer needs to offer severance pay to the employee, then the employer is bound to do so.

If you have not yet received severance payments under your employer?s agreement, you can take assistance from the Employee Benefits Security Administration (EBSA). They shall be able to help you in this regard. However, you will need to ensure here that you lost your employment involuntarily. It mostly applies when employees get terminated, not because of their doings.

Is Severance Pay Taxable?

According to Publication 4128 (Tax Impact of Job Loss) of the IRS,

?Severance pay is taxable in the year that you receive it. Your employer will include this amount on your Form W-2 and will withhold appropriate federal and state taxes. See Publication 525, Taxable and Nontaxable Income, for additional information.?

Basically, severance pay is taxable, just like your regular income, where you will need to withhold tax from your severance check or severance receipt. You can fill out your severance pay collection and withholdings on the IRS Form W2.

The Severance Pay Taxation Process

If you get salary payments, you will need to pay federal income taxes, federal unemployment tax, medicare, as well as Social Security. The same applies to severance pay as well. You can allow withholding of taxes from your severance payments in these two ways:

1. Severance Pay As Regular Wages

If you are about to get severance pay from your employer, and your employer treats the payment just like regular wages, they will withhold all the taxes before you receive anything.

Furthermore, if you receive your money as a lump sum, the tax bracket will be higher in such cases. This is because you are receiving payments for multiple weeks and months on a single pay period. This makes it appear as if your earning is more.

2. Severance Pay As Supplemental Wages

If your severance pay is treated as supplemental income by your employer, they will need to withhold a flat 22% for federal taxes. For supplemental wages that exceed $1 million per year, the tax percentage to withhold is 37%.

How To Minimize Taxes On Severance Pay?

Based on what your situation is at the moment or your age, location, and lifestyle, you can do a variety of things to minimize your taxes on severance pay. Here are some of the useful ways you can try out effectively:

1. Contribute To An Individual Retirement Account

According to a piece of expert advice on Investopedia,

?One easy way to pay fewer taxes on severance pay is to contribute to a tax-deferred account like an individual retirement account (IRA). The contribution limit is $6,000 for 2022 ($6,500 in 2023). You can put in an additional $1,000 if you’re over 50, which counts as a catch-up contribution.?

However, many experts are of the opinion that socking away as much as you can is the best option. You must try to contribute the maximum amount to your IRA to get more advantages.

2. Put Money For Health Expenses

If you have a High-deductible Health Insurance Plan, then you must consider putting your severance payments in your Health Savings Account (HSA). This is a great way if you want to plan for your future expenses and not contribute to your retirement account.

3. Receiving Severance Pay Over A Course Of Time

Your employer sends your severance money over the course of two separate years. If your employer spreads out the payment, then you are not getting the amount in a lump sum. Hence, you shall be able to minimize the taxes on those severance payments you get.

4. Invest In A 529 Plan

You can invest in a 529 plan if you want to support the education of your child (or anyone else). Not only can you minimize the taxes, but you can even get state deductions on those taxes for your contributions.

5. Investing In A Donor-Advised Fun

If you want to support your favorite organization, you can invest in a donor-advised fund to minimize the taxes on your severance package. You can even have a say in how the organization receives your money.

Wrapping Up

Hence, you can see from this article that your severance pay is taxable, just like your regular payments. However, you will be able to reduce your tax bill through various ways. For example, if you direct your severance package to your individual retirement account, you can reduce the tax.

If you want to minimize your tax for severance payments, consider using the tips and techniques given above. Do you have any more recommendations on how to minimize taxes for severance packages? Share your ideas with us in the comments section below.

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