Getting laid off is never good news, but if you get a severance package, it can be a boon to your savings account. It can allow you to do training while you look for a new job, bump up your emergency fund, or pay off debt. But one thing many people don’t take into consideration is that they’ll have to pay taxes on their severance. Thankfully, there are several ways to lessen the tax burden.
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 2019 and 2020. If you’re over 50, you can put $1,000 more. Pamela Capalad, a certified financial planner (CFP) at Brunch and Budget, said you should try to contribute the max if you can take advantage of that opportunity.
Some employers might allow you to put your severance pay into your 401(k). The 2019 limit is $19,000 and an additional $6,000 if you’re over 50. The limit rises to $19,500 in 2020, with an additional $6,500 for those above 50.
Put It Toward Health Expenses
For those who have high-deductible health insurance plans, 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.
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 so you can 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,” said Tyler Landes CFP, accredited investment fiduciary (AIF) and founder of Tandem Financial Guidance, LLC. “That could mean big changes to how much you owe."
Open a 529
If you have kids or want to support a young niece or nephew’s college education, you could use your severance pay to invest in a 529 plan for them. You’ll possibly get some state deductions for contributing.
Make sure to read through the rules carefully to see what the limits are 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 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 that are 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 also supporting your favorite organization. The best part of the donor-advised fund is that it allows the person to get the tax benefit, while also 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," Landes said.
The Bottom Line
Once you find out you’re going to be receiving a severance package and don’t know what you want to do, talk to a professional. A certified public accountant (CPA) and a CFP 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.”