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Is Severance Pay Taxable?

George Simons | August 17, 2022

Summary: The IRS generally considers severance pay as regular income, but there are some exceptions. Here is SoloSuit's guide on severance pay taxes and how you can minimize them for your benefit.

If you lose your job, your employer may pay you a lump sum known as severance pay. This pay may also include other benefits, although it differs from one employer to another.

Former employees use severance pay to cater to their financial obligations while out of employment. However, this money comes with some tax obligations they must fulfill.

Here's all you need to know about severance pay and its taxes, how to minimize those taxes, and other frequently asked questions about severance pay.

What is severance pay?

Severance pay is a payout to an employee following their job termination. In most cases, the employment termination doesn't result from the employee's fault. Instead, it's often a result of structural changes in the company, such as relocation, acquisition, or business closing.

Therefore, the employer may need to make a few staffing adjustments, including laying off some employees in the company.

Although most employers issue severance pay to their terminated employees, there are no laws mandating them to give employees this package. For this reason, the severance pay packages and requirements differ from one employer to another. For example, some employers require the terminated employees to sign an agreement that they won't sue the employer for wrongful termination.

However, some states mandate employers to pay their employees a severance package under a few circumstances. For example, if the employer is closing a business facility or laying off a certain percentage of their employees.

Does the IRS tax severance pay?

Severance pay is taxable. Generally, the IRS treats it as a regular wage. Therefore, it's subject to the following payroll taxes.

  • Social Security tax of 12.4%
  • Medicare tax of 2.9%
  • Federal Unemployment tax of 6% on the first $7,000

The employer and the employee share equal responsibility for paying the Social Security and Medicare taxes. Therefore, the employer pays half of the required tax amount while the employee pays the other half. However, the Federal Unemployment tax is entirely the employer's responsibility.

In addition, the employer is responsible for paying a flat rate of 22% tax income withholdings to the IRS, given that the IRS classifies severance pay as a supplemental wage. Therefore, it is subject to federal and state income withholding deductions. However, the income withholding amounts vary depending on the employee's tax bracket, tax filing status, and the state they live in.

You can minimize your severance pay taxes

If your employer terminates your employment after many years of working with them, you'll likely receive a considerable amount of severance pay. However, this money equally bears huge tax responsibilities. However, you may use a few financial options to manage your finances and minimize the severance pay taxes.

Put the money in a health savings account

If you have high deductible health insurance plans, you may put your severance pay in a Health Savings Account (HSA) to fund your future health expenses. In addition, the HSA account has numerous tax advantages that lower your tax expenses. These benefits include:

  • The employer may exclude contribution to the HSA account from your gross income.
  • Earnings in the HSA accounts aren't subject to tax.
  • Qualified medical expenses from the account are tax-free.

HSA accounts have annual contribution limits that you must abide by before saving your money. For example, the maximum HSA contribution amount for an individual in 2022 is $3,650 and $7,300 for families.

Contribute to an individual retirement account

An Individual Retirement Account allows you to save for retirement and grow your money on a tax-deferred basis. Therefore, contributing your severance pay into such an account lowers its tax deductions.

An IRA also has contribution caps. For instance, the IRA contribution limit for 2022 is $6,000. If you're 50 years, you can contribute $1,000 more as a catch-up contribution.

Spread Out the Severance Payouts

Lump-sum severance pay may elevate your income to a higher tax bracket. Consequently, your tax deductions will be higher.

Instead of taking lump-sum payouts, you may speak to your employer about spreading the payout within two or more years. Then, you won't have to deal with extravagant tax deductions all in one year.

Contribute to the 529 plan

You may also consider saving your severance pay in the 529 plan for your kids' college education. The 529 plan is a tax-advantaged account used to save and pay for qualified education benefits for a designated beneficiary.

Some of the tax benefits of the 529 plan include:

  • Tax-deferred growth
  • Tax-free withdrawals
  • Tax-free gifting of up to $80,000 for individuals or $160,000 for couples filing jointly
  • State deductions for contributions into the account

Unlike other options, the 529 plan has no annual contribution limits. Instead, the IRS considers contributions to these accounts a completed gift for tax purposes.

Frequently Asked Questions About Severance Pay

Here are some commonly asked questions about severance pay and its tax deductions.

What does the severance pay package include?

The severance pay packages differ from one employer to another. Generally, the package may include:

  • A lump-sum amount
  • Accrued vacation time
  • Extended benefits
  • Unreimbursed business expenses

And more.

How is severance pay calculated?

Employers consider different factors when calculating an employee's severance pay. Usually, the calculation is based on the employee's employment duration and salary. However, in other cases, the employer may also consider the employee's position in the company and the reason for employment termination.

One standard model for calculating an employee's severance pay is to give two weeks' pay for every year the employee worked in the company. For instance, an employee who worked for ten years in a company receives a severance pay equivalent to 20 working weeks.

Can severance pay be garnished?

If there's a wage garnishment order against you for an unpaid debt, the collector can't garnish your unemployment benefits such as Supplementary Security Income or Pension and Retirement benefits.

Unfortunately, most people confuse severance pay to be an unemployment benefit. Even though the payment is made to a former employee, the IRS treats it as an income. Therefore, it is subject to taxes, federal deductions, and court-ordered garnishments.

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