Tax Implications of Severance Pay: Is Severance Taxable? - Tax Help USA

Transition periods in professional careers often come with financial decisions, one of which is managing severance pay. As companies restructure or downsize, many employees find themselves with severance packages, pondering over the best ways to handle this financial boon.

What Is Severance Pay?

Severance pay is a form of financial compensation awarded to employees upon the discontinuation of employment. It acts as a bridge between jobs, providing economic support during the job-search period. 

The rationale behind severance pay is multifaceted—it acknowledges past service, offers support during unemployment, and, in many cases, is part of a severance agreement that precludes future legal claims against the company. Calculations for severance pay typically consider the length of employment, the position held, and sometimes the circumstances leading to termination.

Who Gets Severance Pay?

Not every employee is automatically entitled to severance pay. Eligibility for severance pay can depend on company policies, employment contracts, or legal requirements. In the U.S., the Worker Adjustment and Retraining Notification (WARN) Act mandates severance for certain employees affected by large-scale layoffs, but for many others, it is a matter of negotiation and company discretion. Executives and long-term employees are more likely to receive severance, and it is often included in the negotiated terms when they are hired.

Is Severance Pay Taxable?

The short answer is yes—severance pay is taxable. The Internal Revenue Service (IRS) treats severance pay as supplemental income, which is subject to federal income taxes. Depending on where you reside, it may also be subject to state and local taxes. 

Employers typically withhold taxes from severance pay at a flat rate, which may differ from your regular income tax rate, but the total tax liability will be reconciled when you file your annual tax return.

How to Avoid Tax on Severance Pay?

Completely avoiding severance pay tax is not achievable as it is considered taxable income by the IRS. However, there are legal avenues to reduce the immediate tax impact and manage the overall tax burden it creates.

How to Minimize Taxes on Severance Pay 

To manage the tax bite on severance pay effectively, consider the following strategies:

  1. Put the Money in Your Health Savings Account

Contributions to a Health Savings Account (HSA) are tax-deductible, and the funds grow tax-free. The money in the HSA can be used for a wide range of medical expenses, offering a flexible, tax-advantaged financial resource.

  1. Save for Retirement

Directing a portion of severance pay into a retirement account like an IRA or a 401(k) can provide immediate tax relief, as contributions to these accounts can be tax-deductible. Moreover, this move bolsters your retirement savings, allowing the funds to grow tax-deferred until retirement.

  1. Open a 529 Plan

Funding a 529 education savings plan can offer tax advantages. While contributions are not federally tax-deductible, many states offer tax benefits for contributions, and the earnings grow tax-free when used for qualified education expenses.

  1. Spread Out Your Payments

If your severance pay is significant, receiving it in a lump sum can bump you into a higher tax bracket. By spreading the payments across tax years, you may manage to stay in a lower bracket, thus reducing the tax rate on your income.

  1. Make Charitable Donations

Charitable giving can yield tax deductions if you itemize your tax return. This strategy can help offset the taxable amount of severance pay, potentially lowering your overall tax liability.

Get Help Navigating Your Taxes! 

Handling severance pay and its tax implications can be complex. TaxHelpUSA provides expert guidance to ensure that you make the most of your severance while adhering to tax regulations. Our tax professionals can assist with planning and implementing strategies to maximize your severance benefits and minimize tax liabilities.


Why Do Companies Offer Severance Pay?

Severance pay is a benefit offered by companies to support employees during their transition after employment ends.

How Much Is Severance Pay?

Severance pay varies and is typically based on factors like length of service, job position, and company policy.

Are All Employees Entitled to Severance Pay?

Not all employees are entitled to severance pay; it depends on company policy, employment contracts, and legal stipulations.

Is Severance Taxed at a Higher Rate?

Severance is taxed as ordinary income, not at a higher rate, but a lump sum can place you in a higher tax bracket for the year received.

How Will Severance Pay Affect My Tax Refund?

Severance pay can affect your tax refund by increasing your taxable income, potentially leading to a lower refund or higher tax payment.