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
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 pretax 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. If you contribute to a traditional IRA, this money isn’t taxed until it’s withdrawn in retirement. If you contribute to a Roth IRA, you pay taxes now, but not when it’s withdrawn in retirement.
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.
