Is Severance Pay Taxable?

Disclaimer: We are not qualified tax professionals and are not giving advice. Always speak with a qualified professional before making any legal or financial decisions.

If you have been let go from your job or you retired, you may receive severance pay. The short answer to “Is severance pay taxable” is yes, it is considered taxable income by the IRS.  Depending on your state of residence, you may or may not be taxed by the state. However, there are some ways to invest your severance pay that may lessen your tax burden.

In recent years, economic shifts and technological advancements have led to an increase in layoffs across various industries. The U.S. Bureau of Labor Statistics highlights the impact of these changes, noting a significant decline in employment and a steady unemployment rate of 6.7 percent, nearly double the pre-pandemic level.

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What is Severance Pay?

Severance pay is a benefits package that some employers offer. It is not the same thing as your final paycheck. A severance package intends to tide over employees while they look for another job. 

Severance pay is tied to your length of employment and your wage or salary. Often, a company will offer a week or two of pay for every year you have worked for the company. It can include retirement account benefits, stock options, job search assistance, and health insurance coverage for a limited amount of time. 

There are some legal requirements under the Worker Adjustment and Training Notification Act (WARN Act) that a company must meet to mandatorily pay employees severance pay.

Conditions that must be met:

• An employee is losing their job due to layoffs, not because of under-performance
• A company laying off more than 100 employees must give 60 days notice

In addition, you may get severance pay in exchange for:

• Signing a non-disparagement clause
• Not suing the company for discrimination, unpaid wages, or wrongful termination

Is Severance Pay Taxable Income?

The IRS collects two taxes from your severance pay. The first is the standard tax withholding that is collected from any paycheck. This money is applied toward your federal income tax. If your state taxes severance pay, that money will be deducted as well. The amount depends on your current tax withholding.

Severance pay is considered taxable wages under FICA. The employment tax on your severance pay is 7.65% of the package.

Is  Severance Pay Taxable in California?

California levies a standard deduction of 6% on severance packages. If this amount is not withheld, you will have to make estimated payments. Other states have different tax levies on severance pay.

When Do You Get Your Severance Pay?

While the federal government does not set time limits on the final paycheck, many states do, often by the next payday. Severance pay has time limits set by an agreement between you and the company. 

You may get a lump sum or several installments, and it may come as a physical check or be direct-deposited. 

For tax purposes, consider asking the company to make installment payments in two different tax years. Check with your company to see how you will receive your severance pay.

Can I File for Unemployment If I Get a Severance Package?

Depending on your state of residence, you may be able to file for unemployment. Check with your unemployment office to see when you can apply for unemployment. 

Uses for Your Severance Pay

If you need the money to survive, that is what you should do with your severance pay. However, there are other places that squirreling away your severance pay can put you in a better financial position. 

An emergency fund is a great place to put money. If you do not already have one, set up a separate savings account and put a portion of your pay into it. ONLY use the funds for true emergencies and instead of your credit card.

Another great place is a debt reduction fund. Either use the money to pay down bills or set some aside to help you pay down future bills or big-ticket purchases. 

If you love to travel, put some money away for future trips. If you have flexibility in how you spend your severance pay, take advantage of that windfall. 

How Can I Minimize Taxes on my Severance Pay?

If you can survive without your severance pay, you may be able to decrease your tax burden. Since we are not tax professionals, always speak with a tax professional before you make any financial decisions.

The simplest way to lower your taxes on your severance pay is to contribute to a tax-deferred account such as an IRA or 401(k). If you have an HSA (health savings account), you can put part of your severance pay in that against future health care expenses. Education IRAs like 529s are a good place to cut down on your taxes. 

As mentioned above, you may be able to request that your severance package is paid in installments in two different tax years. A lump sum payment can temporarily push you into a higher tax bracket. 

A final way to save on taxes is to donate money into a donor-advised fund at your favorite charity.

**Always speak to a financial professional before making any tax related decisions.**

How to Negotiate Your Severance Package

If you are facing a layoff, you may be able to negotiate the terms of your severance package. Here are some tips:

• Research typical severance packages in your role and industry. Use this data to support requests.
• Consider asking for non-salary benefits like extended health coverage, job placement assistance, and neutral employment references.
• If layoffs are coming, volunteer to leave in exchange for a package.
• Get any negotiated terms in writing before agreeing to separation.

Healthcare and COBRA Considerations

If you have employer healthcare coverage, you have options once separated:

• You can elect COBRA to continue your health insurance. Severance funds can help cover the cost.
• Look into getting coverage through a spouse's plan or the healthcare.gov marketplace.
• If you have an HSA or FSA, understand timelines for extensions and spend downs after job loss.

Retirement Accounts and Severance

Once separated from your employer, you'll have decisions about retirement savings:

• You typically can no longer contribute to that employer's 401k plan.
• You may be able to roll over your 401k balance into an IRA account to keep saving.
• If you have a pension, review your payment and withdrawal options.
  

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