Many unemployed professionals can benefit from receiving severance payments, which can help them build their savings. At the same time, they search for new work, return to school, or invest in their professional development. However, severance pay is considered taxable income, and recipients have an obligation to report this income to the Internal Revenue Service (IRS) when they file their tax returns.
What Does It Mean to Get Severance Pay?
When an employee is let go involuntarily, such as in the case of a layoff, many companies provide financial compensation known as severance pay. In most cases, the amount is determined by the total amount of time you spent employed by the company that is closing its doors. Although it is not necessary for employers to provide severance pay to employees whose employment has been terminated, the majority of businesses do so anyway. At the time of the employee's termination from employment, the employer and the employee will negotiate severance pay.Is There a Tax on Severance Pay?
Along with unemployment compensation and payments for accumulated vacation and sick time, severance pay is taxable in the year it is received, just like any other compensation you might receive. The process of paying taxes is typically made easier by employers who include the amount on their employees' Forms W-2 and who withhold the appropriate amounts of federal and state taxes. In most cases, these taxes are deducted from severance payments:- Tax on Social Security income at a rate of 12.4% (6.2 percent each from the employer and the employee)
- 2.9 percent Medicare tax (1.45 percent each from the employer and the employee)
- Withholding of taxes on the federal income (varies by your tax bracket and filing status)
- Tax deducted from residents' wages by the state (varies by state, tax bracket, and filing status)
- On the first $7,000 in wages, the employer is responsible for paying 6 percent of the federal unemployment tax (FUTA).
How to Reduce the Amount of Taxes That You Owe on Your Severance Pay
If you want to reduce the amount of tax you have to pay on your severance pay, you have a few options.Invest It in Your Health Savings Account
Contributing to a health savings account, also known as an HSA, is an excellent way to reduce the amount of money that you have to pay in taxes while also putting money aside for potential future health and medical costs. HSAs, or health savings accounts, are accounts that are funded before taxes and can be used to pay for qualified healthcare expenses. The maximum amount that can be contributed to an HSA by an individual in 2022 is $3,650, while the maximum amount that a family can contribute is $7,300.Save for Retirement
It would be in your best interests if you also gave some thought to the possibility of making contributions to an individual retirement account (IRA). Starting in 2022, you will be able to put up to $6,000 per year into an IRA, or up to $7,000 if you are at least 50 years old. The funds you put into an IRA will not be subject to taxation until you withdraw them during retirement. You also can contribute funds to a Roth IRA, which requires you to pay taxes at the time of deposit but exempts those funds from taxation when they are withdrawn. In either scenario, IRAs can help you pay less tax to the federal government. You might even be eligible to make contributions to your employer's 401(k) plan, which in 2021 has an annual limit of $19,500, plus an additional $6,500 for people over 50. This limit will be raised to $20,500 in 2022, whereas the additional boost of $6,500 will remain unchanged.You Should Space Out Your Payments
Think about approaching your employer with the idea of negotiating a staggered severance payment. It is possible for you to lessen the burden of paying a single large tax liability by dividing a severance package up and distributing the payments over two or more years. Your tax bracket and the tax rate that corresponds to it may be lowered if you make staggered payments.Contribute to the Cost of Education
Some individuals who receive severance pay make the decision to invest the money in a 529 plan. These plans are vehicles for tax-favored savings that parents typically utilize in order to save money for their children's future educational expenses. Rules for these plans can vary from state to state, but under no circumstances are participants required to pay federal or state income taxes on their earnings (although the contributions are). You can put the funds to use to cover any and all educational expenses, from kindergarten all the way through higher education.Frequently Asked Questions (FAQs)
What Is the Amount of Severance Pay?
When calculating severance pay, it is common practice to factor in the employee's base salary and the total amount of time the company employs. If a company offers two weeks of pay for every year of employment, and you work for that company for five years, you might receive ten weeks' worth of wages at the end of your employment. As part of a separation package, an employer will frequently continue providing health insurance benefits for an employee for a predetermined amount of time. The ultimate value of the severance package is determined by mutual agreement between the employee and the employer. Former workers have the right to continue their health insurance coverage through their employer's plan for a set period after leaving the company, but they must pay the premiums themselves.Who Is Entitled to Get Severance Pay?
If the employer who is terminating the employee chooses to provide a severance package, the employee's current employer will pay them severance pay. In the event of a layoff, employees are typically eligible for severance pay from their employers. It is not common practice for employers to make severance payments to former workers who were fired "for cause" or for conduct-related reasons. When employers do decide to provide severance pay to terminated employees, it is common practice for them to demand that the employee sign a separation agreement in exchange for the money. These agreements typically prohibit the former worker from making derogatory statements about the company, disclosing confidential information, or taking a job with a company that is in direct competition with the former employer.What Kind of Impact Does Severance Pay Have on Unemployment Rates?
It is dependent on the state whether or not severance pay has an effect on the unemployment rate. The administration of unemployment benefits is left up to the states, and each state has its own distinct rules and regulations. Examine your state's unemployment policies as they correlate to severance. In certain states like Texas and New York, receiving severance benefits can result in a reduction in unemployment benefits or cause their receipt to be delayed. Make sure you contact your state's unemployment office to find out its policy. If the state in which you work is different from the state in which you live, it is possible that you will need to check with both states. In certain circumstances, if you want to be able to make the most of the potential benefits, it may be a good idea to negotiate the terms of your severance package with the assistance of an employment law specialist.