How to Minimize Taxes on Severance Pay

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.

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. 

For 2022

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.
  

For 2023

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."

Open a 529 Plan

If you have kids or want to support a young niece or nephew’s college education, consider using your severance pay to invest in a 529 plan. You may even get some state deductions for contributing.

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.

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.”