While losing your job can be a stressful event, severance pay may help you deal with your regular expenses for a few weeks or months. Many employers offer severance pay, so you don’t have to worry about your bills while you’re looking for a new job.

While it can be a good source of income while you transition to a new job, you may be wondering, “How is severance pay taxed?” It’s taxable as your regular income and is subject to income tax withholding. In this guide, we’ll go deeper into how it’s taxed, factors that impact how much tax you pay, and strategies to minimize your tax obligation.  

What Is Severance Pay?

Severance pay is a type of compensation that an employer will pay to employees when they’re terminated. While federal or state laws don’t mandate severance pay, it’s common for companies to offer it in layoffs.

The amount of pay you receive depends on factors such as your salary, industry norms, and length of employment.

Is Severance Pay Taxable?

If you’ve recently been let go from your job, you may be wondering, “Is severance pay taxable?” The answer is yes. You’ll pay severance pay tax for the year you receive it, but how much will be withheld will depend on how it’s paid out.

“Severance pay is like any other form of income,” says Teresa Dodson, founder of Greenbacks Consulting. “It's taxable.”

There are two ways your employer may pay your severance. It can either be paid as a part of your wages or apart from it. When paid as a part of your wages, your normal withholding that applies to your employment tax will apply to the severance payment.

If severance pay is paid apart from your wages, a flat 22% withholding rate will apply for federal income taxes. Keep in mind that your final tax bill may be different at tax time. For example, you may have overpaid or underpaid tax. This means that you may either owe a tax debt or get a refund.  

Is Severance Taxed Differently Than Income?

Severance is not taxed differently than regular income. Taxes on severance pay are calculated based on your income tax bracket. However, if you receive a large lump sum amount within a year, it may push you into a higher tax bracket, which can result in a larger tax bill.

Is It Taxed Differently in Different States?

So, how is severance pay taxed at the state level? Severance pay is taxable and is subject to federal and state taxes. Employers must withhold state taxes from the severance pay, like your regular wages, and you must report it as income on your tax return.

Your state income withholding tax will vary depending on the state you reside in, your filing status, and your tax bracket. For example, some states like Alaska, Nevada, and Washington don’t have state income tax, while California and New York have a state withholding tax. 

Factors Impacting the Taxation of Severance Pay

Severance pay tax can vary based on a number of factors, such as how much you receive and your tax bracket.

Amount Received

The additional income you receive through severance pay may put you into a higher tax bracket. If you receive a lump sum amount, this can be a sizeable increase in your income for that year. Like taxes on lottery winnings, you may owe more in taxes.

You may pay more in taxes when you’re in a higher tax bracket. This is similar to how bonuses are taxed.

Tax Bracket

The progressive tax rate bracket system in the U.S. means that your marginal tax rate may change due to severance pay. For example, if you’re ordinarily in the 22% tax bracket and get bumped into the 24% bracket due to severance pay, a part of your income will be taxed at a higher rate.

How Else Can Severance Affect Your Taxes?

Other than tax on severance pay, there are other things to consider with job loss. Losing your job will typically result in losing your insurance. If you have a Flexible Spending Account (FSA) through your employer, you may have to forfeit those funds if you don’t continue insurance coverage through COBRA.

Check to see if you qualify for the advance premium tax credit, which can help you pay health insurance premiums.

5 Tips To Minimize Taxes on Severance Pay

There are several things you can do to minimize taxes on severance pay. Consider some of the options we’ve listed below.

1. Retirement Account

One way to pay less severance tax is by contributing more to an individual retirement account (IRA). For 2023, the contribution limit is $6,500, and if you’re over the age of 50, you can contribute an additional $1,000 as a catch-up contribution.

Check if your employer allows you to use severance pay to contribute to your 401(k) account. For 2023, the contribution limit is $22,500, and if you’re over the age of 50, you can contribute an additional $7,500 as a catch-up contribution.

2. Health Expenses

You can also contribute to a health savings account (HAS) to minimize your taxable income and get a larger tax refund. These are pretax accounts that allow you to save for health or medical expenses.

The contribution limits for HSAs for 2023 are $3,850 for individuals, with an additional contribution room of $1,000 for those over 50 years old. The contribution limit for families is $7,750.

3. Payout Timing

Another strategy for minimizing your tax obligation is through staggered payments. Instead of receiving the entire severance pay at once, you can spread it out over a few years to reduce your tax liability in a single year.

4. 529 Plan

529 plans are tax-advantaged plans that help parents save for their children’s education expenses. In some states, contributions to 529 plans are tax deductible, but there may be a limit on the total amount of deduction allowed. Check your state’s 529 plans to see how much you may be able to deduct.

5. Donor-Advised Fund

donor-advised fund is an account sponsored by a charitable organization. The account will hold your contributions and will allow them to grow for future grants or distributions. With a donor-advised fund, you’ll get the tax benefit while supporting your preferred charitable organization.

Pay Less Taxes on Your Severance Pay  

Paying tax on severance pay may seem complicated, but it’s automatically withheld and needs to be reported as earned income when you file taxes at the end of the tax year. Speak to a tax professional to learn more about how to minimize your tax liability.

While paying extra tax can be challenging when you’re already dealing with a job loss, the additional funds you receive after withholding can help you manage expenses while you look for a new job.