Money Health

How is Severance Pay Taxed?

How is Severance Pay Taxed
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As the coronavirus crisis continues to drag on, PPP funds are running dry, some businesses aren’t able to resume full operations, layoffs are increasing and even some furloughs are turning into layoffs.

For laid off employees who are fortunate enough to get one, a severance package can provide much-needed funds to pay the bills while they search for a new job. And if you’re someone has who received a severance package, it’s important to be aware that severance pay is taxed, so the amount in the severance letter isn’t the exact amount that will go into your bank account.

Severance pay is taxed by the IRS the same as wages—you’ll have to pay employment (FICA) tax and income tax withholding at your usual rate. The same goes for other taxable income on your final paycheck, including unused vacation time, commissions, bonuses, etc.

First, let’s get clear on exactly what severance pay is, how it is taxed, and how it differs from other pay that might be in your final paycheck.

What is Severance Pay?

Severance is pay provided to an employee after employment is over, usually with the intention of helping them cover expenses while they look for a new job.

Providing severance pay is not required by law, and it may be negotiated between the employer and employee. You can ask for a greater amount of severance pay than what the employer initially offers, and they may or may not be willing to comply. Your severance is often based on the length of time you have spent at the company.

Depending on the company, a severance package may include other perks in addition to pay, such as:

  • Retirement account benefits
  • Stock options
  • Job search assistance
  • Extension of health insurance coverage during the severance period

Severance pay usually is not the same thing as your final paycheck. Your final paycheck may include other pay in addition to severance pay.

Severance Pay Taxes

There are two types of tax you’ll have to pay on any severance money you receive: your withholding and employment tax.

Tax Withholding

This money is taken from each paycheck and withheld for the taxes paid in April. It’s your money and will be applied toward what you owe the government for state and federal taxes. There will be one deduction for federal income tax and, depending on where you live, another for state income tax. You can expect to pay the same percentage of withholding on your severance pay as on your regular wages.

Employment Tax

Often called the FICA tax (which stands for the Federal Insurance Contributions Act), this tax is also taken out of every paycheck and goes to fund Social Security and Medicare. You will pay a total of 7.65% of your severance pay in employment tax.

Here’s a detailed breakdown of severance pay taxes:

You Pay Employer Pays Total
Social Security tax 6.2% 6.2% 12.4%
Medicare tax 1.45% 1.45% 2.9%
Total employment tax 7.65% 7.65% 15.3%
Federal income tax withholding Your current withholding % N/A Varies by tax bracket
State income tax withholding Your current withholding % N/A Varies by bracket and state rate

When Will Severance Be Paid?

Although federal law doesn’t require employers to give you your final paycheck on your last day, many states require companies to pay employees right away, especially if the employee is laid off unexpectedly.

Within state guidelines, companies can set their own policies on when they issue your final paycheck. Make sure to ask your employer when you’ll receive all the money that is owed to you, if it will be in one check or multiple checks, and if the funds will be paid by physical check or via direct deposit.

What Will You See on Your Final Paycheck?

Your final paycheck is different than your severance pay. Your final check may include some or all of the following, all of which will be taxed:

  • Wages, commissions, bonuses, etc. that you earned recently but haven’t yet been paid for
  • Any lump-sum severance amount
  • Payout for unused vacation or personal time, if any

What you might see deducted from your final paycheck, in addition to tax deductions:

  • Elective premiums. If you’re signed up for any employment benefits such as health insurance, FSA plan, legal plan, etc., these premiums can be taken from your regular earned income.
  • Retirement fund contributions. If you’re contributing to a retirement fund like a 401(k), your employer may direct some of your earned income into your retirement fund as usual, but not any of your severance pay.
  • Money owed to the company. If you have company equipment that you did not return or you owe the company for things like a salary advancement, these can be taken out of your severance pay.

Will Severance Pay Be Enough?

When you’re laid off, the first thing to do after you file for unemployment benefits is put together an emergency budget to help you get through your time without a paycheck. This will tell you the absolute minimum amount of money you need to get by each month.

Once you know how much your basic needs cost each month, you can look at the money you have coming from your final paycheck and any other income sources, and calculate how long those funds will last.

Whether or not you’ll have enough money depends on several factors, such as:

  • The amount of your severance
  • What state unemployment benefits you can get
  • How long it takes you to find another job
  • What your expenses are currently
  • If you can find other sources of income, like a side gig, to bring in additional income

What Should You Do with Your Severance Pay?

If you’re in a tough spot financially, then the money will need to go to paying bills. But if you have enough savings or income from another source to cover your basic expenses, then you have some other options for using your severance money. You could put it in a:

  • Retirement account
  • Health Savings Account (if you already have one)
  • 529 college savings account
  • Emergency savings fund
  • Travel fund
  • Debt payment fund

Using Your Severance Money to Pay Down Debt

If you’re considering using severance funds to pay off debt, check out our free How to Manage Debt Guide, which goes over the different ways you can reduce your debt and the pros and cons of each. By knowing your options ahead of time, you can make sure your severance pay goes as far as possible in knocking down your debt.

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Sara Korn is a freelance writer who enjoys guiding people to helpful solutions and new and better ways of reaching their goals. She loves stories both on screen and on the page, and is passionate about learning, growing, and teaching.