Is Severance Pay taxable?

Severance Pay

Losing your job is a stressful enough experience, but many people also have to deal with a sudden change in their income. The good news is that many employers are willing to compensate terminated employees with a severance package. This compensation may come in the form of a lump sum or in the form of regular payments following a set schedule. Severance pay is usually based on years of service, though some companies may use a different formula – often involving seniority and a job title. Some severance packages may include other compensation, such as compensation for unused vacation or sick time.

Whether your severance pay is taxable depends on how it’s paid out and what your other sources of income are during the year. If your employer pays the severance pay as part of your normal wages, you’ll have to deal with federal income tax withholding that’s calculated using your W-4, plus state and FICA (which covers your share of Social Security and Medicare) taxes.

On the other hand, if your employer pays out the severance pay as what the IRS calls “supplemental wages,” you’ll be subject to a flat withholding rate of 22%, rather than the standard marginal tax rate that’s applied to your other earned income. That’s a big difference, especially if the severance pay is substantial and hits you all at once.

Is Severance Pay taxable?

It’s important to understand how a severance package will impact your tax liability and to consult with a trusted tax professional to ensure that sufficient taxes are withheld. If you have concerns, you can try to reduce your tax bill by asking your employer to pay out your severance payments over several years instead of in one lump sum. In addition to saving on the severance tax rate, this strategy may help you avoid a large bump in your income that could push you into a higher tax bracket.

You can take additional steps to reduce the amount of severance pay lawyer that’s subject to taxation, including contributing to a tax-deferred retirement account, adding funds to a health savings account, or opening a 529 college savings plan for your child. You can even donate to charity with qualifying contributions, which will allow you to lower your taxable income.

You’ll have to wait until tax filing season to see if the withholding was sufficient, but these strategies will give you peace of mind that you’re not facing a surprise tax bill at filing time. If your employer did not withhold enough, you can file a tax refund claim. But don’t wait until the last minute to do so – you should begin making your claim as soon as possible to prevent any delay or loss of your refund. For more information about this topic, watch our one-hour webinar on demand: Tax Filing and Planning Strategies for Unexpected Income. Register for a free NerdWallet account or sign in to access the recording.