Does the IRS Consider Severance Pay as Income?
Yes, any amount of severance pay is considered earned income by the IRS for tax purposes. Payment for unused sick and vacation time included in a severance pay package is also counted as income.
In most cases, taxes withheld on severance pay are the standard 12.4% Social Security tax (6.2% from the employee and employer), Medicare tax of 2.9% (1.45% from the employee and employer), and state income taxes.
Currently, the IRS withholds a 6% federal employment tax that employers must pay on the first $7,000 of a severance check.
Are Federal Taxes Withheld from Severance Checks?
Yes, but the amount of federal taxes withheld from severance checks varies based on the recipient’s filing status and tax bracket. The IRS has recently issued 2024 tax brackets that should be applied to severance pay received after January 1, 2024.
Does Severance Pay Show Up on Your W-2?
Severance pay is reported on W-2s, along with wages and withholdings. However, withholding amounts do not determine if you owe taxes. You will need to adjust wage and withholdings on your 2024 tax return to calculate whether you owe taxes or could be eligible for a refund.
Most people can find severance pay in the “Wages, Tips, Other Compensation” box on their W-2 forms. If severance pay is subject to Social Security taxes, it may be included in Box 3 (Social Security wages). Severance pay subject to Medicare taxes may be included in Box 5 (Medicare Wages and Tips).
Does the IRS Tax Severance Pay as Regular Wages or Supplemental Wages?
A severance payment is considered supplemental income when issued in a separate check or bank deposit.
For example, if your last regular pay from your ex-employer includes a lump sum severance payment, the severance payment would not meet the definition of supplemental wages.
On the other hand, if your last regular pay is deposited into your bank account, followed by a separate deposit for your severance pay, the IRS would consider that severance payment as supplemental wages.
When employers treat a severance check as supplemental income, a flat rate of 22% for federal taxes could be withheld. However, severance pay exceeding $1 million for any given tax year will be taxed by the IRS at a flat rate of 37% if it is considered supplemental income by the employer issuing the severance.
Can Severance Pay Move You Into a Higher Tax Bracket?
Receiving a lump sum severance package can move you into a higher tax bracket depending on the deductions and adjustments you are eligible to take. However, if severance pay pushes your total income into a higher tax bracket, only the additional amount within that bracket is subject to higher taxes.
Are Employers Mandated By Law to Give Employees Severance Pay?
While no federal law mandates employers to provide severance pay to employees who have been laid off or terminated, the Worker Adjustment and Retraining Notification (WARN) Act does require some employers to provide workers with a 60-day notice before their last day on the job.
The WARN Act does not direct employers to offer severance pay unless employees have entered into a contract specifying such compensation upon termination.
How Can You Lower Your Tax Liability When You Have Extra Income From Severance Pay?
There are several ways to reduce your tax liability if you receive severance pay:
- Contribute severance pay to an IRA
- Put some or all of your severance pay into a Health Savings Account (HSA) or other deductible health insurance plan
- Start a 529 plan with some or all of the severance payment (529 plans are intended to encourage saving for education expenses and are sponsored by educational institutions and state agencies)
You could also request an extended severance payment schedule from your employer, so you do not receive the severance in one lump sum. Instead of receiving the full amount of severance up front, some employers will divide payments into smaller payments over several months or even years.
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