If your job pays you a severance when you get laid off, you’ll usually pay the same taxes as regular wages. However, there are a few things to be aware of.
Is severance pay taxable?
A severance package is taxable just like any other wages or employee compensation. The reason is that even though you’re no longer working, it’s still consideration for your past contributions to the company.
If it sounds unfair to have severance pay taxed, there are a couple of things that might make you feel a little less bad.
First, the IRS taxes all sources of income. Even if you find buried treasure, you have to pay income tax.
Second, if the IRS didn’t tax severance pay, people would figure out how to game the system. You’d probably see CEOs getting laid off in May with a tax-free severance package and getting rehired after their summer vacation.
Severance Pay Tax Rate
The tax rate on your severance pay is your usual federal income tax rate. It won’t change unless you move down a tax bracket due to losing your job or move up a tax bracket due to finding a better job.
FICA taxes, including Social Security tax and Medicare tax, do apply to severance pay. The Supreme Court confirmed this in the 2014 case United States vs. Quality Stores. The reason is that since severance pay is compensation for work (even past work), it’s still earned income that should be subject to the usual taxes on wages.
State income taxes usually apply to severance pay as well. This might surprise you since states like California don’t tax unemployment. States tax severance pay for the same reasons the IRS does.
Severance Pay Tax Withholding
One thing to watch out for is that income tax withholding on severance pay often works the same as it does for bonus taxes. That means your employer might withhold a flat rate of 22% instead of basing the tax withholding on the size of your severance package.
If you’re usually in a higher tax bracket, you’ll probably owe income taxes when you file your tax return. You might want to set some money aside when you get your severance.
If you’re usually in a lower tax bracket, you can probably expect a larger refund when you file.
Severance Pay and Retirement Contributions
If you wanted to use your severance pay to make one last 401(k) contribution and maybe get an employer bonus, this is where it gets unfair.
Under the 401(k) rules, severance pay is generally not considered compensation. Once your employment ends, you typically can’t contribute more to your 401(k).
Some payments that you were already entitled to anyway may allow you to make a final contribution. These can include your final paycheck, banked time off, earned bonuses or commissions, and deferred compensation.
If you’re trying to minimize taxes and can’t contribute to a 401(k), you might want to contribute to an IRA or HSA.
Check Your Health Insurance
If you lose the job that you had your health insurance through, visit HealthCare.gov to check your options. You may be eligible to use a marketplace health insurance plan instead of an expensive COBRA plan.
Marketplace plans often have cheaper monthly premiums, and you may qualify for a subsidy or tax credit due to having lower income.
Severance Pay and Unemployment
Severance pay may or may not affect your unemployment eligibility. It depends on what state you live in and whether you receive a lump sum or get paid over time.
There’s usually no harm in applying for unemployment as long as you’re truthful on your application. You may also want to check out Unemployment Taxes to see what you’ll owe on your unemployment benefits.
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