Is Severance Pay Taxable? Know Your Options

A severance package can be an unexpected and emotionally charged payout for any employee. Just as unexpected might be the sudden tax responsibility that comes along with a severance package.

You do have some options on your side when it comes to navigating a settlement package and what your responsibilities are come tax time. Here are some key things to know if you have received or anticipate receiving a severance payout. Call a California employment law attorney with any further questions about severance pay as an employer or employee.

What Is Severance Pay?

Severance pay is a payment package that is often given to employees following a job termination. Typically, severance packages are given to employees who through no fault of their own end up getting terminated. This often occurs when there is a layoff throughout a company.

A severance package is usually calculated by the length of time you worked for the company. For example, some companies offer two weeks of severance pay for every year the employee has worked for the organization. Employers are not required by law to offer severance packages; however, many do. The final details of a severance package can at times be negotiated by the employee and employer as well.

Is Severance Pay Taxable?

If you have worked at a company for several years, a severance package can be a hefty sum of money. Regardless of how much the severance payout is, employees are still required to pay taxes on the severance package as they would with any taxable income they receive.

A large severance package can throw an employee off because their responsibilities for the tax at the end of the year can be large and unexpected. However, there are options available to you when it comes time to pay the taxes on your severance package.

Ways to Minimize Taxes on Your Severance Pay

You have a couple of financial options available to you in order to minimize how much taxes you pay on your severance package. These options do not eliminate the fact that you will inevitably have to pay taxes on your severance package. However, they can make it more manageable and even beneficial for you to minimize how much and when you pay the taxes.

1. Put the Money in Your HSA

The first method in minimizing your tax responsibility is by putting the money in a Health Savings Account (HAS). This type of account is a great way to both delay your tax payment and fund future health expenses. HSAs are funded with pre-tax dollars that can be used toward your medical needs. As with any account, there are contribution limits that you must adhere to. For 2021, individuals are capped at $3,600 in annual contributions while families have a cap of $7,200.

2. Put the Money in a Retirement Account

Another place to put your severance pay is in a retirement account. If you contribute to an individual retirement account (IRA), you can avoid paying taxes on the money until you begin withdrawing it for retirement. This tax advantage lies in the fact that as you get older, you may fall into a lower tax bracket. This will allow you to be taxed at a much lower level when you do begin tapping into your IRA.

You can also contribute funds from your severance package to a Roth IRA. While you will be taxed on the contribution of your Roth IRA, the tax advantage lies in the fact that your IRA can help you reduce your overall federal tax payment.

In some instances, you may also be able to contribute money to your employer’s 401k. Much like HSAs, there are also contribution limits to these retirement accounts. IRAs have a cap of $6,000 a year, while 401ks have an annual limit of $20,500 starting in 2022. If you are age 50 or older, you can contribute an additional $6,500.

3. Put the Money in a Tax Advantage Education Account

You may also want to consider putting money from your severance package into a 529 plan. These types of accounts are tax advantage savings plans that allow parents to put money away for their children in order to fund their education. Depending on the type of plan you have, the rules may vary. While there are taxes associated with the contributions, you will not be taxed on the earnings.

4. Spread Out Your Severance Pay

It can be beneficial to negotiate with your employer about having your severance paid out over the course of two or more years. Doing so will allow you to lower your taxable income for the year. This can also help you fall into a lower tax bracket as well. When you fall into a lower tax bracket, the corresponding tax rate will be lower as well.

Obtaining Legal Assistance for Your Severance Pay

If you have been terminated from your job or anticipate that you might be terminated soon, there may be grounds to negotiate your severance package. This is especially the case if you have worked at the organization for an extended period of time.

Having a qualified attorney by your side can help you maximize your severance package and guide you in terms of your tax responsibilities. Call Coast Employment Law at 714-551-9930 for help negotiating a severance package as an employer or employee in Orange County.