Do You Have to Pay Tax on a Severance Payment After Job Loss?

Pay Tax on a Severance Payment After Job Loss

When a company lets an employee go, it often offers the departing worker a payout known as a severance package. This money may come as a lump sum or in installments and can be helpful for a former employee to establish a budget or find a new job. However, like any income, severance pay is taxable.

When it comes to taxation, a lot depends on how the company pays the severance package and what the worker does with it. For example, if the company gives the severance package as part of the worker’s normal wages, it would withhold federal income tax (using the employee’s W-4 form), state income taxes and Social Security and Medicare taxes the same way it does for regular paychecks.

If, on the other hand, a former employer chooses to treat the severance pay as what the IRS calls “supplemental wages,” it’s subject to federal income withholding at a flat rate of 22%. This applies even when the severance pay is considered a bonus and isn’t guaranteed to be paid every year.

In either case, the severance pay and any compensation for accumulated vacation and sick time are added to the worker’s taxable income in the year they receive it. The total is then reported on the worker’s Form W-2 that her former employer sends her by January 31 of the following year.

Do You Have to Pay Tax on a Severance Payment After Job Loss?

The additional income hitting the former worker all at once could bump her into a higher tax bracket, which is why some workers prefer to get their severance pay in regular installments rather than as a lump sum, according to Brunch and Budget. The latter option also allows the worker to spread out her tax liability, which makes financial sense.

Whether the how to get severance pay is a lump sum or in installments, the worker should consider directing a portion of it to an individual retirement account (IRA) or a health savings account (HSA). This can lower her overall tax bill and help her retire with a nest egg. Alternatively, she can earmark the money to be donated to charity through a donor-advised fund, according to Clark.

If she’s worried that insufficient federal taxes were withheld from her severance pay, she can contact her former employer’s human resources department and ask for more tax to be withheld. She can also file an amended return, but this process is more complex and requires the help of a tax professional. A certified public accountant can provide personalized advice for her specific circumstances. In any event, the tax laws are complicated and every situation is different, so it’s a good idea to consult with a professional before making any big decisions.