How Is Severance Pay Taxed?

Severance Pay and Tax Withholding

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 to help former employees cover expenses while looking for a new job.

Although it can be a good source of income while you transition to a new job, you may be wondering, “How is severance pay taxed?”

Severance pay is taxable as regular income and is subject to income tax withholding. In this guide, we’ll go deeper into how this form of income is taxed, factors that impact how much tax you pay, and strategies to minimize your tax obligations.

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 this benefit in the event of layoffs.

Is Severance Pay Taxable?

Yes, severance pay is taxable. You’ll owe taxes on severance pay for the year you receive it, but the amount 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 part of your wages or apart from them. When paid as part of your wages, your normal employment tax withholding 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 your taxes. This means that you may either owe tax debt or get a refund.

Is Severance Taxed Differently Than Income?

Severance is not taxed differently from 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 Severance Taxed Differently in Different States?

Severance pay is subject to federal and state taxes. Employers must withhold state taxes from severance pay just like 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 Florida don’t have state income tax, while California and New York do collect income tax at the state level.

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 yearly income. Similar to taxes on lottery winnings, you may owe more after receiving a large sum of money. This is also how bonuses are taxed if you receive this type of income.

Tax Bracket

The progressive tax rate 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, 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 items to consider during a 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

Consider the following options to minimize taxes on severance pay.

1. Contribute to a Retirement Account

One way to pay less severance tax is by contributing more to an individual retirement account (IRA). The 2025 contribution limit for an IRA is $7,000 for those under 50 and $8,000 for those aged 50 and up.

Check if your employer allows you to use severance pay to contribute to your 401(k) account. For 2025, the contribution limit to a 401(k) was raised to $23,500. If you’re aged 50 or older, you can also add $7,500 as a catch-up contribution.

2. Add to Health Expenses

You can also contribute to a health savings account (HSA) 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 2025 are $4,300 for individuals enrolled in a high-deductible health plan, or $8,550 for family coverage. Individuals over 55 can contribute an additional $1,000.

3. Use a Donor-Advised Fund

A 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.

4. Create a 529 Plan

A 529 is a tax-advantaged plan 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. Control Payout Timing

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

Pay Fewer Taxes on Your Severance

Taxes on severance pay may seem complicated, but once you report it as income, a tax professional can help you understand what you owe and mitigate costs.

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

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