How to Minimize or Avoid Paying Taxes on Severance Pay

Receiving a severance package after leaving a job can provide crucial financial support during your transition period. However, that relief might be dampened when you realize how much of your severance pay could be claimed by taxes. Severance payments are typically subject to income tax. However, there are legitimate strategies to minimize or eliminate taxes on severance pay. This helps you keep more of your earnings. Your departure may have been voluntary or part of a company restructuring. Either way, understanding the tax implications of your severance package can help you maximize its value. From strategic timing of your payment to utilizing retirement account contributions and exploring potential deductions, this is how to avoid tax on severance pay.

A financial advisor can help protect you against crucial tax burdens you may not need to pay.

How Severance Pay Works

Severance pay is compensation provided by employers to employees who are terminated due to circumstances beyond their control. These payments typically come as part of a severance package. This can happen when an employee is laid off, a position is eliminated or a company undergoes restructuring. The amount often correlates with factors like length of employment, position level and company policy.

Comprehensive severance packages often extend beyond just monetary compensation. They may include continued COBRA health insurance coverage or outplacement services to help with job searching. It can also include payment for unused vacation or sick time. Some employers might also offer to maintain certain benefits, like life insurance, for a limited period.

Most employers calculate severance pay based on a formula considers years of service. A common approach is to offer one or two weeks of regular salary for each year worked at the company. For executives or senior-level employees, this formula might be more generous, sometimes offering a month’s salary per year of service.

How severance pay works can vary significantly between companies. Some employers distribute the payment as a lump sum, providing the entire amount at once. Others may choose to continue regular salary payments for a designated period. It essentially keeps the employee on payroll without the work responsibilities. Each method carries different tax implications and timing considerations.

How Severance Pay Is Taxed

Severance pay is considered taxable income by the IRS. This means it is subject to federal income tax withholding just like your regular wages. When you receive a severance package, your employer typically withholds taxes at a flat 22% supplemental wage rate. However, higher earners may see a 37% withholding on amounts exceeding $1 million. This withholding includes not just federal income tax but also Social Security and Medicare taxes (FICA).

How your severance pay is taxed can vary, depending on whether you receive a lump sum or installments. A lump sum payment might push you into a higher tax bracket for that year. This results in a larger tax burden. However, payments spread across multiple tax years could help keep you in a lower tax bracket each year. This reduces your overall tax liability.

Beyond federal taxation, your severance pay is also subject to state and local income taxes in most locations. The rates vary significantly depending on where you live. Some states have no income tax at all, while others may charge rates approaching 13% or more. It is important to account for these additional tax obligations when planning how to manage your severance package.

Certain components of your severance package may be taxed differently. For example, payment for unused vacation or sick time is taxed as regular income. However, if your severance includes continued health insurance coverage, this benefit typically is not taxable.

Additionally, the rules change if your severance agreement includes compensation for damages like emotional distress or discrimination. These amounts may have different tax implications, depending on the specific circumstances.

Ways to Reduce Taxes on Severance Pay

After leaving a job, severance pay can provide financial stability during your transition. However, it often comes with a significant tax burden. Understanding how to avoid taxes on severance pay can help you retain more of your hard-earned money during an already challenging time.

Contribute to retirement accounts: Consider moving severance pay into qualified retirement accounts like a 401(k) or IRA. This can reduce your taxable income for the year. These contributions may be tax-deductible. This effectively lowers the amount of severance pay subject to immediate taxation, while simultaneously building your retirement savings.
Request payment distribution across tax years: If possible, negotiate so your severance is paid across multiple tax years. This is instead of one lump sum. This strategy can prevent your income from being pushed into a higher tax bracket in a single year. The difference could potentially save you thousands in taxes.
Offset with deductible expenses: Consider timing deductible expenses to coincide with the year you receive severance pay. This might include expenses such as medical expenses or charitable contributions. These deductions can help offset the additional income and reduce your overall tax liability.
Explore health savings accounts: If eligible, direct some severance pay into a Health Savings Account (HSA). This provides a triple tax advantage: tax-deductible contributions, tax-free growth and tax-free HSA withdrawals for qualified medical expenses.
Negotiate for non-taxable benefits: Work with your employer to structure part of your severance package as non-taxable benefits rather than direct pay. Items like outplacement services, health insurance continuation or career counseling may be provided tax-free.

Finding ways to reduce taxes on severance pay requires careful planning. Consider consulting with a tax professional who can help you implement these strategies effectively.

Bottom Line

Understanding how to avoid tax on severance pay can significantly impact your financial situation during a job transition. Utilize strategies like leveraging retirement accounts, negotiating payment timing and exploring health benefit options. This way, you can potentially reduce your tax liability. Remember that severance packages represent both an opportunity and a tax event that requires careful planning.

Tips for Tax Planning

A financial advisor with tax experience can help you understand how to protect your assets and prepare in advance for future tax liability. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
If you’re curious what you might owe in taxes next year, consider estimating it with an income tax calculator.