How Is Severance Pay Taxed?

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Severance payments can help many out-of-work professionals bolster their savings while they look for new jobs, go back to school, or invest in professional development. But severance pay is taxable, and recipients are required to report these earnings to the IRS when they file their tax returns.

Key Takeaways

  • Severance pay is money employers pay to employees following a job termination, such as a layoff.
  • Severance pay is taxable, just like regular wage or salary income, in the year of payment.
  • Like regular income, federal and state taxes on severance pay are usually withheld by the employer.

What Is Severance Pay?

Severance pay is money that many companies remit to their employees upon involuntary termination, such as a layoff. It's typically calculated based on the length of time you worked for the terminating organization. Employers are under no obligation to grant severance pay to terminated employees, but many choose to do so. Severance pay is negotiated between the employer and the employee at the time of termination.

Is Severance Pay Taxable?

Severance pay is taxable in the year of payment, along with any unemployment compensation you receive and payments for accumulated vacation and sick time. Employers usually simplify the tax payment process by including the amount on your Form W-2 and withholding the appropriate federal and state taxes. These taxes are typically 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 and filing status)
  • State income withholding tax (varies by state, tax bracket, and filing status)
  • 6% federal unemployment tax (FUTA) paid by the employer on the first $7,000

Note

The Social Security tax has a wage base limit of $160,200 in 2023. Income over this amount in a given year isn't subject to the tax. The wage base limit can increase periodically to keep up with inflation.

A 0.9% Additional Medicare Tax applies to wages that exceed $200,000 for single taxpayers, or $250,000 for those who are married and filing a joint return. There's no ceiling on wages subject to the Medicare tax.

How To Minimize Taxes on Your Severance Pay

Several options exist if you're hoping to minimize your severance pay tax bill.

Put the Money 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 and medical expenses. HSAs are pre-tax accounts that can be used toward health or medical needs. The 2023 HSA contribution limit stands at $3,850 for individuals and $7,750 for families (individuals 50 years old and older may contribute an additional $1,000).

Save for Retirement

You might also want to consider contributing to an individual retirement account (IRA). You can contribute up to $6,500 a year to an IRA for tax year 2023, or up to $7,500 each year if you're age 50 or older, and this money isn't taxed until it's withdrawn in retirement.

Note

You may even be able to contribute to your employer’s 401(k) plan, which has an annual limit of $20,500 in 2022, plus an additional $6,500 for individuals over 50 years old. This limit increases to $22,500 in 2023, plus an extra $7,500 for savers over 50 years old.

Spread Out Your Payments

Consider negotiating a staggered severance 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.

Help Pay for Education

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

Frequently Asked Questions (FAQs)

How much is severance pay?

Severance pay is often calculated as a function of salary and time spent at the company. You might be paid 10 weeks’ wages if you worked for a company for five years and they offer two weeks of pay for every year of employment. Employers often continue health insurance benefits for a limited period of time as part of a severance package. The ultimate severance value is agreed upon between the employer and employee. Separating employees are also entitled to continue health insurance coverage through their employer's plan at their own expense for a limited period.

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 layoff situations. It's unusual for companies to pay severance to employees who were terminated “for cause” or for conduct reasons. Employers will frequently require the terminated employee to sign a separation agreement in exchange for the severance pay when they do pay it. 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?

The effect of severance pay on unemployment depends on the state. Individual states administer unemployment benefits, and they each have their own unique sets of rules. Check with your state’s unemployment office to determine its policy. You may have to check with two states if your state of employment differs from your state of residence. It may be a good idea to consult with an employment law expert to structure your severance agreement to enable you to maximize potential benefits in some situations.

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Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
  1. IRS. "Publication 15, Employer's Tax Guide."

  2. IRS. "Topic No. 751 Social Security and Medicare Withholding Rates."

  3. IRS. "Topic No. 759 Form 940 – Employer's Annual Federal Unemployment (FUTA) Tax Return – Filing and Deposit Requirements."

  4. IRS. "Rev. Proc. 2022-24."

  5. IRS. "Retirement TopicsIRA Contribution Limits."

  6. Internal Revenue Service. "Traditional and Roth IRAs."

  7. IRS. "Retirement Topics - 401(k) and Profit-Sharing Plan Contribution Limits."

  8. IRS. "Topic No. 313 Qualified Tuition Programs (QTPs)."

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