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. Keep reading to find out how to cut down on your tax bill to Uncle Sam.
- 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 the 2021 tax year. 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, who is 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 2021 limit is $19,500. You can save an additional $6,500 if you’re over 50.
Put It Toward Health Expenses
For those who have 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 $3,600 for self-coverage or a maximum of $7,200 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 $7,000 or $14,000 for self- 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 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,” 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
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 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 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 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.
If you donate cash or cash equivalents (transfers, checks), you can get a deduction of as much as 60% of your adjusted gross income (AGI).
“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 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), CFP, or other financial professionals 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.”