How Severance Pay Is Taxed

Losing your job can be a significant financial setback. However, severance pay can help soften the blow. When you lose your job involuntarily, your employer may offer severance pay as a goodwill gesture to help you stay on your feet while you transition to a new job.

Severance pay is taxable as regular income, and taxes are withheld from your severance check. Severance pay is included on your annual W-2, which should make it easy to report this additional income at tax time. But to better understand how severance pay is taxed, here’s a quick primer on how it works.

Severance pay is taxed the same as your regular wages. You’ll pay federal income taxes, Social Security, Medicare, and federal unemployment tax, just as you would on your regular pay.

Taxes are generally withheld from your severance check in one of a few ways:

• As regular wages: If your employer treats your severance check as regular wages, they’ll withhold federal and state income taxes, Social Security, Medicare, and so on before you ever see a dime. If you receive your money in a lump sum, there’s a chance your withholding will be calculated using a higher tax bracket.
• As supplemental wages at a flat 22%: If your employer treats your severance check as supplemental income, they may withhold only a flat 22% of it for federal taxes.
• At 37% on supplemental wages that exceed $1 million in a year: If you receive $1.2 million in severance pay, for example, $200,000 of it will be subject to a flat 37% withholding.

Your severance pay and any taxes withheld will be reported on your W-2, along with your regular wages and withholding. Withholding doesn’t determine how much you’ll owe at tax time: You’ll reconcile wages and withholding on your tax return to calculate how much you owe—the same way you do in a normal tax year.

How to Mitigate the Tax Impact of Severance Pay

Depending on when you start working (and getting paid for) a new job, severance pay could increase your income—and your tax bill—for the year. Say, for example, that you start working at a new job right after leaving your old one. The money you receive as severance is “extra” taxable income that is over and above your normal wages. In some cases, this could even edge you into a higher tax bracket.

If you want to minimize taxable income, you may be able to lessen the tax impact of severance pay by contributing to a tax-advantaged account. Here are a few possibilities:

• Contribute to your 401(k) or other employer-sponsored plan
• Contribute to a traditional IRA, as your contribution is tax-deductible in the year you contribute
• Contribute to a health savings account (HSA) if you have a qualifying high-deductible health plan

If you itemize your deductions, you can deduct qualifying charity donations of up to 50% of your adjusted gross income. You might also consider asking your employer to split your severance payments between two years—for example, by making one payment in December and a second one in January. That way, the additional income you receive in severance won’t hit your tax bill all at once.

What if Losing Your Job Means a Significant Loss of Income?

Even with severance pay, your income may be down for the year if you are out of work for an extended time. If that’s the case, putting cash into a retirement fund or HSA probably isn’t your top priority; using your severance pay to cover expenses makes more sense.

If you replaced your employer’s health plan with insurance from a marketplace, you may be eligible for the advance premium tax credit. You may also qualify for the earned income tax credit if your income is lower due to unemployment.

Tips for Preparing for Tax Season

Because losing (or changing) your job and receiving severance pay can complicate your taxes, this could be the year to consider working with a professional tax advisor. A tax pro can help you ensure that you’ve accounted for all of your income and withholding, maximized your credits and deductions—and may be able to help you gauge whether you’ll need to pay additional taxes at tax time or make a quarterly estimated payment now.

Here are a few things to think about as tax time approaches:

• Mind Contribution Deadlines: Contributions to an employer-sponsored plan like a 401(k) must be made in the year you take the deduction. For 2023, the deadline to contribute is December 31, 2023. IRA and HSA contributions must be made by the tax-filing deadline in the following year—for example, by April 18, 2023, for the 2022 tax year.
• Double-Check Income and Withholding: Your W-2 should reflect your wages and severance pay, as well as funds withheld for federal and state income taxes, Social Security, Medicare, federal unemployment tax, and retirement contributions. Double-check for accuracy and let your employer know if you find a discrepancy.
• Account for Additional Income: Severance pay aside, you may have additional unemployment-related income to account for on your taxes, including:
  • Unemployment benefits
  • Vacation and sick pay you redeemed when you left your job
  • Pension withdrawals
• File by the Usual Deadline: Tax season typically kicks off in early February. You can’t file sooner than the IRS start date, even if you expect a refund and would like to get it early.

The Bottom Line

Paying taxes on severance pay adds an item or two to your mental to-do list—and, certainly, no one likes paying additional taxes. Still, paying taxes on severance is better than not getting severance at all. The additional funds can help smooth the transition to your next career move and help manage expenses, including timely payments on your credit cards and loans to keep your credit reports in good shape.

If you have any mortgage service needs, don’t hesitate to call O1ne Mortgage at 213-732-3074. Our team of experts is here to help you navigate your financial journey with ease and confidence.