Severance pay can be a big boon to many out-of-work professionals, providing them with much-needed income that can help them bolster their savings and bridge the gap between unemployment and new career opportunities. While it can provide a financial cushion for when things get bad, you’ll need to revamp your money spending habits until you find a more stable source of income.
What you need to know is that there is still withholding of tax on severance pay, just like regular pay, and this is reliant on several factors. What exactly is included in severance pay? How is it taxed? In this article, we’ll answer these questions and more, helping you to navigate the process of reporting your severance income on your tax return.
What Is Severance Pay?
Firstly, severance pay is not the same thing as the final paycheck from a job you quit. Rather, it’s an extra payment given by your employer because they’ve decided to terminate your employment with them. Severance pay is an agreement between the employee and employer that is made when an employee is terminated from a position. However, it’s important to remember there’s no legal requirement for employers to offer severance pay. There are also no federal laws governing how much an employer must pay in severance if they go down this route.
Most companies that provide severance pay do so because they want to reduce the chances of a lawsuit by the employee. In other words, it’s a way to soften the blow of losing a job. The severance package can be negotiated by both parties so it can vary widely in what it includes.
Severance packages usually include:
Pay: This could include both base salary and overtime pay. It could also include commissions earned from sales or bonuses earned by meeting certain goals set by the employer.
Benefits: These include any type of benefit such as health insurance coverage, dental insurance coverage, and life insurance coverage. They also include things like 401K plans and other retirement plans if they were offered through the company’s HR department.
Bonuses: These could include bonuses that were promised when an employee was hired or bonuses that were promised after one year of service with the company.
The exact amount paid out will also vary depending on what type of job was held by the employee (i.e., whether they were hourly or salaried), how long they worked for their employer, how many years of experience they had, and whether any unused vacation days were included in the settlement agreement. There is no average severance package, and each case is unique.
How Is Severance Pay Taxed?
Severance pay is typically taxable income for employees who receive it as part of their separation package from an employer. It is considered to be supplemental pay rather than compensation for services rendered during the time they were employed by the company.
These standard deductions may include:
- Federal Income Tax – This is affected by your tax bracket which is dependent on income level and filing status.
- Social Security and Medicare Taxes (FICA) – Social Security and Medicare taxes are withheld from all earned income (including severance pay), at rates of 6.2% each for Social Security and 1.45% each for Medicare tax.
- State Income Tax – This differs according to your state’s tax rates, brackets, and filing status.
There are also certain cases where special rules are in effect such as when supplemental pay exceeds the value of $1M for a year, the excess amount is subjected to withholding at the mandatory flat rate of 37%. Another is if the supplemental value does not exceed $1M for a calendar year, then a flat rate of 22% is withheld. However, there are nuances to these rules, such as whether supplemental wages are combined or identified separately from regular wages, to name one.
In short, if you’ve received severance pay this year or are currently considering an offer of severance pay from your employer, know that it will be subject to tax. You’ll want to get a sense of how much you’ll receive based on the details of your contract, understand what your tax responsibilities are going to be depending on your circumstances, and even negotiate for the best severance package if possible. As with all financial matters, it’s better to consult a tax specialist for additional guidance before making any major decisions.
Written by: James Deutsch
About the author:
James Deutsch is a content strategist and self-appointed globe-trotter with a passion for interior decor, DIY projects, and of course, travelling. In his free time, he enjoys writing about the art of decoration, home maintenance, events, and gift giving.