Is Severance Pay Taxable? How to Minimize Your Tax Bill

Losing your job is stressful enough without worrying about taxes. But if you receive severance pay, you need to know the tax implications. The short answer: yes, severance pay is taxable income.

You can reduce your tax burden with smart planning. We’ll show you exactly how to minimize taxes on your severance package.

What Is Severance Pay?

Severance pay is compensation your employer gives you after termination. You typically receive it when job loss isn’t your fault.

Common reasons for severance packages include company restructuring, business closures, or relocations. Your employer may need to reduce staff for financial reasons.

No federal law requires employers to provide severance pay. Each company sets its own policies and requirements. Some employers ask you to sign agreements waiving your right to sue.

A few states do mandate severance in specific situations. These include mass layoffs or facility closures affecting many workers.

How the IRS Taxes Your Severance Pay

The IRS treats severance pay as regular wages. You’ll owe the same payroll taxes as normal income.

Your severance is subject to these taxes:

• Social Security tax: 12.4% (split between you and employer)
• Medicare tax: 2.9% (split between you and employer)
• Federal Unemployment tax: 6% on first $7,000 (employer pays)
• Federal income tax withholding: typically 22% flat rate

You and your employer each pay half of Social Security and Medicare taxes. Your employer handles the Federal Unemployment tax entirely.

Severance counts as supplemental wages for tax purposes. The IRS requires a 22% flat withholding rate in most cases. Your actual tax depends on your bracket, filing status, and state.

Four Ways to Reduce Severance Pay Taxes

Large severance payments mean substantial tax bills. You can use strategic financial moves to lower your tax burden.

Consider these four options to minimize taxes on severance pay:

• Fund a Health Savings Account (HSA)
• Contribute to an Individual Retirement Account (IRA)
• Request installment payments instead of lump sum
• Invest in a 529 education savings plan

Each strategy offers unique tax advantages. You can use one or combine multiple approaches.

Use a Health Savings Account

Do you have a high-deductible health insurance plan? You can put severance money into an HSA.

HSAs provide three major tax benefits:

• Contributions reduce your taxable income
• Account earnings grow tax-free
• Withdrawals for medical expenses are tax-free

The 2024 HSA contribution limit is $4,150 for individuals. Families can contribute up to $8,300.

Contribute to an IRA

Individual Retirement Accounts help you save for retirement with tax advantages. Your contributions may reduce your current taxable income.

The 2024 IRA contribution limit is $7,000. If you’re 50 or older, you can add an extra $1,000.

Your money grows tax-deferred until retirement. Traditional IRA contributions may be tax-deductible depending on your income.

Spread Out Severance Payments

A large lump sum can push you into a higher tax bracket. You’ll pay more in taxes than necessary.

Ask your employer about spreading payments over two or more years. You’ll avoid the tax spike from one large payment.

Smaller annual payments keep you in a lower tax bracket. You’ll save money on your overall tax bill.

Fund a 529 Education Plan

Planning for your children’s education? A 529 plan offers excellent tax advantages.

The 529 plan provides these tax benefits:

• Tax-deferred growth on investments
• Tax-free withdrawals for qualified education expenses
• Tax-free gifting up to $80,000 per individual or $160,000 for couples
• Potential state tax deductions on contributions

Unlike IRAs and HSAs, 529 plans have no annual contribution limits. The IRS treats contributions as completed gifts.

What Your Severance Package May Include

Severance packages vary widely by employer. Your package might include more than just cash.

Common severance package components:

• Lump-sum cash payment
• Payment for unused vacation days
• Extended health insurance coverage
• Reimbursement for business expenses
• Outplacement services

Review your severance agreement carefully before signing. Each benefit may have different tax implications.

How Employers Calculate Severance Pay

No standard formula exists for calculating severance. Employers consider multiple factors when determining your payment.

Most companies base severance on your tenure and salary. Your position level may also affect the amount.

A common formula gives two weeks’ pay per year of service. Work at a company for 10 years? You’d receive 20 weeks of pay.

Some employers offer more generous packages to senior employees. Others provide minimum amounts regardless of tenure.

Can Creditors Garnish Your Severance Pay?

Many people mistakenly think severance is protected like unemployment benefits. It’s not.

The IRS treats severance as regular income, not an unemployment benefit. Creditors can garnish it just like regular wages.

If you have a court-ordered wage garnishment, creditors can take money from your severance. The garnishment follows the same rules as regular paycheck garnishments.

Certain benefits are protected from garnishment, including Social Security Income and most pension payments. Severance doesn’t qualify for these protections.

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How Severance Appears on Your Tax Return

Your employer reports severance pay on your W-2 form. It’s combined with your regular wages for the year.

Your employer withholds taxes based on how they classify the payment. Options include standard wage withholding, 22% supplemental rate, or 37% for amounts over $1 million.

You won’t know your exact tax obligation until you file your return. The withholding amount may not match what you actually owe.

You might get a refund if too much was withheld. Conversely, you could owe additional taxes if withholding was insufficient.