When you lose your job, severance pay can feel like a financial lifeline—but here’s what most people don’t realize: how is severance pay taxed can dramatically affect the actual amount you take home. Unlike regular wages, severance comes with its own tax rules, and the IRS treats it differently depending on the circumstances. Understanding these rules now could save you thousands of dollars and prevent an unwelcome tax bill next April.
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What Counts as Severance Pay?
Severance pay is compensation your employer gives you when you’re laid off, terminated without cause, or sometimes when you accept a voluntary buyout. It’s separate from your regular paycheck and typically calculated based on your tenure, salary level, or both. The IRS considers severance as taxable income—period. Whether you receive it as a lump sum or spread over time, it’s subject to federal income tax, Social Security tax (up to the wage base limit), Medicare tax, and potentially state and local taxes.
One common misconception: severance isn’t “free money” just because you’re not working for it anymore. The IRS views it as wages earned during your employment, making it fully taxable income that must be reported on your Form 1040 tax return.
How Severance Is Taxed by the IRS
The fundamental answer to how severance pay is taxed is straightforward: it’s treated as ordinary wage income. This means:
- Federal income tax: Taxed at your marginal tax bracket (10%, 12%, 22%, 24%, 32%, 35%, or 37% depending on your income level)
- Social Security tax: 6.2% up to the annual wage base ($168,600 in 2024)
- Medicare tax: 1.45% on all wages, plus an additional 0.9% if you exceed income thresholds
- State income tax: Varies by state; some states don’t tax income at all
Your employer must withhold these taxes from your severance payment, just as they do with regular paychecks. However, the withholding method matters significantly—and this is where many people get blindsided.
Withholding Requirements Explained
When your employer pays out severance, they have two withholding options under IRS guidelines:
Option 1: Aggregate Withholding (Most Common)
Your employer combines your final paycheck with your severance and withholds taxes as if it were a single regular pay period. This often results in under-withholding because the calculation doesn’t account for the one-time lump sum nature of the payment. If you normally earn $5,000 biweekly but receive $50,000 in severance, your employer might withhold based on a pattern that no longer applies.
Option 2: Separate Withholding
Some employers treat severance separately and withhold at a flat 22% federal rate (or 37% if it exceeds $1 million). This is more conservative but might result in over-withholding if you’re in a lower tax bracket.
The critical point: request a Form W-4 adjustment immediately if you’re concerned about withholding accuracy. Don’t assume your employer got it right. Many people discover in April that they owe thousands because insufficient taxes were withheld from their severance.
Special Tax Situations for Severance
Certain types of severance packages receive special treatment:
Severance for Breach of Contract or Wrongful Termination
If you settle a lawsuit or receive damages for wrongful termination, the tax treatment depends on what the settlement covers. Physical injury damages are tax-free, but damages for lost wages or emotional distress are taxable. Your settlement agreement should clearly itemize what’s being paid for.
Unused Paid Time Off (PTO)
When you receive payment for accrued vacation days, sick leave, or PTO, it’s taxed as ordinary wages. Some states require employers to pay out all accrued PTO; others don’t. This is a common component of severance packages that people forget to account for in their tax planning.
Signing Bonuses and Retention Bonuses
If your severance package includes a signing bonus for accepting the severance terms, it’s fully taxable. These are treated identically to regular bonuses and subject to the same withholding rules.
Deferred Compensation and Stock Options
If your severance includes vesting of deferred compensation or accelerated stock options, the taxation becomes more complex. Consult a tax professional because these may trigger alternative minimum tax (AMT) considerations or require special reporting on Form 6251.
Estimated Tax Payments and Severance
Here’s where many people stumble: if your employer’s withholding doesn’t cover your actual tax liability, you might owe estimated taxes. This is especially true if you’re self-employed, have investment income, or if the severance pushes you into a higher tax bracket for the year.
Calculate your estimated tax liability using Form 1040-ES. If you expect to owe more than $1,000 when you file, the IRS may assess penalties for under-withholding. Some taxpayers benefit from making quarterly estimated tax payments once they realize their severance won’t be fully covered by employer withholding. Understanding estimated tax payments is crucial if you live in a high-tax state like California, where state income tax can add another 9.3% to your federal burden.
Pro tip: If you receive severance early in the year and know withholding will be insufficient, consider making an estimated tax payment immediately rather than waiting until April. This reduces penalties and interest charges.
Tax Planning Strategies for Severance
Strategy 1: Negotiate the Payment Structure
Before accepting severance, ask your employer if you can receive it over multiple years instead of a lump sum. Spreading severance across two or three tax years could keep you in a lower bracket and reduce your overall tax burden. Not all employers will agree, but it’s always worth asking.
Strategy 2: Maximize Retirement Contributions
If you have access to a traditional IRA or SEP-IRA, contribute as much as possible in the year you receive severance. For 2024, you can contribute up to $7,000 to a traditional IRA (or $8,000 if you’re 50+), which reduces your taxable income dollar-for-dollar. This lowers your AGI, which affects many other tax calculations.
Strategy 3: Consider a Roth Conversion
If you have a traditional IRA, severance year might be an opportunity for a strategic Roth conversion. You’ll pay taxes on the conversion, but if you’re already paying taxes on severance, you might consolidate the tax hit and gain long-term benefits from tax-free growth in the Roth.
Strategy 4: Bunching Deductions
If you itemize deductions, the extra income from severance might push you into a higher bracket. Consider “bunching” charitable donations, medical expenses, or state tax payments into the severance year to maximize itemized deductions. Strategic tax planning around your income can significantly boost your take-home pay.
Strategy 5: Health Insurance Continuation
If you elect COBRA coverage after severance, those premiums are paid with after-tax dollars. However, if you’re self-employed afterward, you can deduct health insurance premiums as an above-the-line deduction, reducing your taxable income.
State and Local Tax Considerations
Federal tax withholding is only part of the picture. State and local taxes can be substantial, and severance is subject to the same rules as regular wages in most states.
High-Tax States: California, New York, Massachusetts, and Vermont impose state income taxes of 8-13.3%. Your severance will be taxed at these rates unless you’re in a state with no income tax (Texas, Florida, Tennessee, etc.).
Out-of-State Work: If you were working remotely for a company in another state, your severance might be taxable in both your home state and the employer’s state. Some states offer credits to prevent double taxation, but you’ll need to file returns in both jurisdictions.
Local Taxes: Cities like New York City and Washington, D.C. impose additional local income taxes on top of state taxes. Make sure your employer is withholding for these as well.
Documentation You’ll Need
When tax time arrives, gather these documents:
- Form W-2: Your employer must issue this by January 31st. Severance should be included in Box 1 (wages) and Box 5 (Medicare wages)
- Form 1099-NEC or 1099-MISC: If your severance was paid by a third party (like an outplacement firm), you might receive this instead
- Severance Agreement: Keep a copy showing exactly what was paid and for what purpose
- Pay Stubs: Document what taxes were actually withheld
- Proof of Withholding: If you made estimated tax payments, keep receipts
If there’s a discrepancy between what your employer said they’d withhold and what actually appears on your W-2, contact them immediately to request a corrected W-2 (Form W-2c) before you file.
Frequently Asked Questions
Is severance pay considered income for unemployment benefits?
This varies by state. Some states reduce your unemployment benefits dollar-for-dollar by the amount of severance you receive, while others don’t. Check your state’s unemployment insurance office website. If you’re in a state that counts severance against benefits, you might negotiate to receive severance over time to preserve unemployment eligibility.
Can I avoid taxes on severance by not cashing the check?
No. The moment your employer issues severance, it’s taxable income, whether you cash the check or not. The IRS considers it earned income in the year it was paid or made available to you. Avoiding the check won’t change your tax liability.
What if my employer didn’t withhold enough taxes from severance?
You’ll owe the difference when you file your tax return. If the under-withholding was substantial, you might also owe penalties and interest. While you won’t go to jail for honest mistakes, you will owe interest and penalties if you underpay. File your return on time and pay what you owe to minimize interest charges.
Can I claim severance as a loss on my taxes?
No. Severance is income, not a loss. However, you might be able to claim a casualty loss if you lost property in a disaster, or a theft loss if you were a victim of crime. But severance itself is never deductible.
How does severance affect my Social Security benefits?
Severance counts as earned income for the year it’s received. If you’re already collecting Social Security and earning above the annual earnings limit ($23,400 in 2024), your benefits will be reduced by $1 for every $2 you earn above the limit. Plan accordingly if you’re near full retirement age.
Should I hire a tax professional to handle severance taxation?
If your severance package is straightforward and your employer withheld correctly, you might handle it yourself. But if your severance exceeds $100,000, includes stock options or deferred compensation, or if you’re dealing with a settlement from wrongful termination, hiring a CPA or tax attorney is money well spent. The complexity easily justifies the cost.
