Severance pay is taxed as ordinary income, and the employer will withhold taxes on it and include it in the employee's Form W-2 for the year.
There are ways to reduce the tax burden. Consider paying some of it into a tax-advantaged retirement or health savings account. If you're a parent, put some in a 529 educational savings account. Or ask the employer to pay the severance out over two years to avoid tax-bracket creep. You can also donate some of it to charity and take the deduction.
- You can reduce your tax bill by directing your severance package to an IRA.
- Consider putting some of your severance into an HSA if you have a high-deductible health insurance plan.
- Ask your employer if the company can pay you out over two years.
- You can use some of the money from your package to fund a 529 plan.
- Consider supporting your favorite charity by using your severance pay for a donor-advised fund.
Contribute to a Retirement Account
One easy way to pay fewer taxes on severance pay is to contribute to a tax-deferred account like an individual retirement account (IRA). The contribution limit is $6,000 for 2022 ($6,500 in 2023). You can put in an additional $1,000 if you're over 50, which counts as a catch-up contribution.
Financial experts say you should try to sock away as much as you can. According to Brunch and Budget's Pamela Capalad, a certified financial planner (CFP), you should try to contribute the maximum amount if you can take advantage of that opportunity.
Some employers may even allow you to put your severance pay into your 401(k). The 2022 limit is $20,500 (the 2023 limit is $22,500). You can save an additional $6,500 if you're over 50 in 2022 ($7,500 in 2023).
Put It Toward Health Expenses
For those with high-deductible health insurance plans (HDHPs), putting your severance money in a health savings account (HSA) is a great way to plan for future expenses if you don’t want to put it toward retirement.
You can save as much as $3,650 for self-coverage or a maximum of $7,300 for family plans as long as:
- Your deductible is more than $1,400 for self-coverage or $2,800 for family coverage.
- Your out-of-pocket expenses max out at $7,050 or $14,100 for self-only and family coverage, respectively.
You can save as much as $3,850 for self-coverage or a maximum of $7,750 for family plans as long as:
Your deductible is more than $1,500 for self-coverage or $3,000 for family coverage.
Your out-of-pocket expenses max out at $7,500 or $15,000 for self-only and family coverage, respectively.
Time Your Payout
An easy way to pay fewer taxes is to have your severance paid out in two separate years. Ask if you can have the payments spread out to avoid taking a huge tax hit in one year. For some people, taking a lump sum can mean owing unexpected money on your taxes.
"Receiving a single large lump-sum payment could push you into a higher tax bracket," according to Tyler Landes CFP, accredited investment fiduciary (AIF) and founder of Tandem Financial Guidance. "That could mean big changes to how much you owe."
Make sure you get advice from a financial professional so you get the best possible tax benefits for your personal situation.
Open a 529 Plan
Please read through the rules carefully to see the limits so your contribution doesn’t count as a gift. You don’t want to cause more of a headache for yourself while you’re trying to lessen your tax burden.
Under the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019, you can also use a 529 to pay off up to $10,000 of your own student loan debt. It may make sense to open a 529 account, get any state tax credits available, and immediately repay student loans.
Invest in a Donor-Advised Fund
A donor-advised fund is a unique way you can offset the taxes you'd pay on your severance while supporting your favorite organization. The best part of the donor-advised fund is that it allows an individual to get the tax benefit while having a say in how an organization receives money.
"These accounts are sponsored by national charitable organizations and hold your contributions and let them grow for future distributions or grants," according to Landes.
Is Severance Taxed at a Higher Rate?
The federal unemployment tax, Social Security, and Medicare are all taxed at the same levels for severance pay. The federal income tax may be at a higher rate, depending on the payment. If the severance payment is made in a lump sum, it might be taxed at a higher rate as it would be higher than the normal amount received per paycheck.
Is Severance Taxed Differently Than Income?
No, severance is not taxed differently than income. It is taxed at the ordinary income tax brackets; however, if the severance pay is made as a lump sum, it may fall in a higher tax bracket.
How Can I Avoid Paying Taxes on Severance?
There is no way to completely avoid paying taxes on severance but there are ways to reduce the amount of severance that will be taxed. This includes putting some of the severance in tax-advantaged accounts, such as HSAs and 401(k)s.
The Bottom Line
Once you find out you’re receiving a severance package and don’t know what you want to do, talk to a professional. A certified public accountant (CPA), CFP, or other financial professional can give you ideas on what to do with your money, even if you think you know what’s best.
“Buyouts are a real gift, so plan accordingly,” said Peter J. Creedon, chief executive officer of Crystal Brook Advisors. “You need to see and understand the whole picture before making a large financial decision.”