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Understanding Severance Pay and Its Tax Implications

Losing your job can significantly impact your finances, but severance pay can help ease the transition. When you lose your job involuntarily, your employer may offer severance pay as a goodwill gesture to support you while you find new employment. However, it’s important to understand how severance pay is taxed and how you can mitigate its tax impact.

How Severance Pay Is Taxed

Severance pay is treated as regular income and is subject to federal income taxes, Social Security, Medicare, and federal unemployment tax. Your severance pay will be included on your annual W-2, making it easier to report this additional income during tax season. Here’s a quick overview of how severance pay is taxed:

• As regular wages: If your employer treats your severance check as regular wages, they will withhold federal and state income taxes, Social Security, and Medicare before you receive the payment. Receiving a lump sum may place you in a higher tax bracket temporarily.
• As supplemental wages at a flat 22%: If treated as supplemental income, your employer may withhold a flat 22% for federal taxes.
• At 37% on supplemental wages exceeding $1 million: For severance pay over $1 million, the excess amount will be subject to a flat 37% withholding.

Your severance pay and any taxes withheld will be reported on your W-2, along with your regular wages and withholding. The actual amount you owe will be reconciled on your tax return.

How to Mitigate the Tax Impact of Severance Pay

Severance pay can increase your income for the year, potentially raising your tax bill. Here are some strategies to minimize the tax impact:

• Contribute to a 401(k) or other employer-sponsored plan: Contributions are tax-deductible in the year you contribute.
• Contribute to a traditional IRA: These contributions are also tax-deductible.
• Contribute to a Health Savings Account (HSA): If you have a qualifying high-deductible health plan, HSA contributions are tax-deductible.
• Make charitable donations: If you itemize deductions, you can deduct qualifying charity donations up to 50% of your adjusted gross income.
• Split severance payments: Ask your employer to split your severance payments between two years to spread out the tax impact.

What if Losing Your Job Means a Significant Loss of Income?

If you are out of work for an extended period, using your severance pay to cover expenses may be more important than contributing to retirement funds. You may also be eligible for the advance premium tax credit if you replaced your employer’s health plan with marketplace insurance, or the earned income tax credit if your income is lower due to unemployment.

Tips for Preparing for Tax Season

Receiving severance pay can complicate your taxes, so consider working with a professional tax advisor. Here are a few tips to keep in mind:

• Mind contribution deadlines: Contributions to employer-sponsored plans must be made by December 31, while IRA and HSA contributions can be made by the tax-filing deadline.
• Double-check income and withholding: Ensure your W-2 accurately reflects your wages, severance pay, and withheld taxes.
• Account for additional income: Include unemployment benefits, vacation and sick pay, and pension withdrawals in your tax calculations.
• File by the usual deadline: Tax season typically starts in early February, and you must file by the IRS deadline.

The Bottom Line

Paying taxes on severance pay may add to your to-do list, but it’s better than not receiving severance at all. The additional funds can help you manage expenses and transition to your next career move. For any mortgage-related needs, feel free to call O1ne Mortgage at 213-732-3074. We’re here to help you navigate your financial journey with confidence.

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