Is Severance Pay Taxable? How Job Loss Affects Your Taxes

Being laid off from work is stressful. Without an income, you might find yourself borrowing too much and eventually end up in need of debt relief.

On a brighter note, some workers are entitled to severance pay. Depending on your situation, it could include several months of your salary.

Is severance pay taxable? Unfortunately, the answer is yes. Severance pay counts as pay. Not only that, but unemployment benefits are also taxable. 

You can ease the sting with some advanced planning. Read on to learn how. 

Is Severance Pay Taxable?

Severance pay is taxable. However, the way it’s taxed and the impact these taxes might have will depend on the details. 

If you understand how taxes on severance pay work, you may be able to reduce the taxes you owe. Keeping those tax costs down makes it less likely you'll need tax debt relief in the future, so it's worth learning the details.  

How job loss affects your taxes

If you lose your job, your income taxes are still based on the amount of money you made that year. This includes:

• Any regular pay you earned before you lost your job

• Severance pay

• Unemployment benefits

Unemployment benefits count as income, but other types of government assistance, such as SNAP benefits, aren’t taxable. 

Your job loss could trigger tax on your retirement savings

If you had a retirement plan through your former employer, the situation is a little more complicated. 

Generally, when you leave your job, you can leave your 401(k) with your old employer. If the balance is under $5,000, though, you may have to move the money out of the employer’s plan. 

In that case, you’ll have 60 days to roll the money over into another qualified retirement plan, such as an IRA. If you miss that deadline, the money is treated as a taxable distribution from the plan subject to ordinary income taxes. 

If you’re younger than 59 1/2, it’s usually also subject to a 10% early withdrawal penalty. 

What happens if you have a loan against your 401(k)?

Some employers allow their employees to borrow from their 401(k) plan. As long as you pay this loan off on schedule, it isn’t taxable. 

Losing your job can disrupt your repayment schedule. 

Typically, 401(k) loans must be fully repaid if you separate from your employer for any reason. They might give you weeks or months to repay the entire loan balance. Otherwise, the unpaid balance could be treated as a taxable distribution. You may also owe the extra 10% tax for an early withdrawal. 

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How Is Severance Pay Taxed In the U.S.?

Severance pay is taxed as ordinary income. However, details such as the tax rate on severance pay and how much is taken out of severance pay for withholding depend on your situation.Is severance pay taxed differently from regular income?

Like your regular income, severance pay may be subject to a few different taxes:

• Income tax: This is based on the income tax rate for the amount you made that year.

• Social Security tax: Social Security gets 12.4% on income up to $176,100 in 2025. Half of this is paid by the employer, and half by the employee. 

• Medicare tax: This is a 2.9% tax, which is also split 50-50 between the employer and you. High-income employees may have an additional 0.9% Medicare tax paid by the employer.

• Federal unemployment tax: This is paid by the employer.

You’re responsible for paying taxes whether or not they’re withheld from your paycheck. When you receive severance pay, your employer will withhold a portion to cover taxes due on the severance. The amount withheld depends on how the employer treats the severance payment. 

Pay is treated like regular wages: Withholding is based on tax rates that apply to a check of that size. A large severance payout could push you into a higher tax bracket.

Pay is treated like supplemental wages: You’ll have 22% withheld for federal taxes.

In a nutshell, the distinction between regular wages and supplemental income can affect how much is withheld from the check you receive.

Taxable vs. nontaxable severance scenarios

Severance pay is taxable, whether you receive it as regular wages or supplemental income. However, you could reduce the tax bite with offsetting deductions.

Examples might include:

• Contributions to a qualified retirement plan

• Medical expenses if you itemize and have expenses exceeding 7.5% of your adjusted gross income

• Mortgage interest on loans up to $750,000 if you itemize on your taxes.

Your eligibility to offset income with these deductions depends on your situation. Tax rules change from year to year, so it's a good idea to talk to a qualified tax professional about your situation and ask how much tax you'll owe on your severance pay.

State taxes and severance pay

You may also have to pay state taxes on severance pay. 

In addition, some localities charge local income taxes that could apply to severance pay.

Everybody’s tax situation is a little different, but here’s an example of how this might work:

• Suppose you’re a single taxpayer in New York City and you’re laid off with a $10,000 severance payment that’s paid all at once.

• Before that, you earned $40,000 in regular wages during the year.

• As a New York City resident, you’d be subject to New York State and New York City income taxes, as well as federal income taxes.

• The rate for all those taxes would be based on $50,000 a year (the combined total of your regular wages and severance pay).

• The federal, New York State, and New York City tax rate for a $50,000 earner would be applied to your $10,000 severance pay. 

Of course, not all states and cities have income taxes. 

Severance pay vs. unemployment benefits

You might receive both severance pay and unemployment benefits when you lose your job. These aren’t the same, and they don’t come from the same source. Here are the main differences:

• Source: Severance pay is from your employer when you're laid off. Unemployment benefits come from the state, although your employer pays to fund the program.

• Taxes: Severance pay is taxable income and is taxed like wages. Unemployment is taxable, but some states give you a break when it comes to taxing unemployment benefits. 

• Impact on benefits: Some states reduce your unemployment benefits if you receive severance pay because severance pay is income. Unemployment, however, has no effect on severance. 

• Duration and amount: Severance pay is often a one-time payment. Unemployment benefits typically last for a set number of weeks, depending on where you live. (Often, it lasts for a maximum of 26 weeks.) During that time, you may have to fulfill your state’s requirements, such as by searching for a new job.

How to Lower the Tax Impact of Your Severance

You can’t change the tax laws, but you may be able to affect how they apply to your severance pay. 

If you’re able to, negotiating the method and timing of your severance payouts and your tax deductions could affect how much tax is taken out of your severance pay. 

Tax planning if you lose your job

A job loss can have significant implications for your financial situation, including what happens at tax time. There are some potential pros and cons to consider when managing your tax liability. 

• Your income may go down. If a job loss means an extended loss of income, that could put you in a lower tax bracket for the year. You may pay less in taxes even if you receive severance pay, vacation pay, sick time, or unemployment benefits. 

• Unemployment benefits are taxable. If you're eligible for unemployment, this could be a valuable lifeline until you're able to get back to work. If given the option, consider letting the state withhold taxes from your payments.  

• Weigh side hustle benefits. A side hustle could generate more income. But you’ll probably have to pay self-employment taxes on the money you earn (you deduct your business costs and pay tax on your profits). If self-employment income is significant, consider making estimated tax payments during the year to avoid penalties. 

• Think carefully about retirement plan withdrawals. If you have no other financial resources to fall back on, you may consider taking an early withdrawal from your 401(k) or IRA but this should be a last resort. That money would be taxable as income, and you could get hit with the 10% early withdrawal penalty if you’re younger than 59 1/2.

• There’s no tax deduction for job loss. Even so, a lower income could make it easier to qualify for the Earned Income Tax Credit (EITC). Tax credits reduce your tax liability dollar for dollar. 

Once you have a handle on how severance might impact your taxes, you can plan to minimize those taxes. Timing and deductions are two ways you can do that. 

Making the most of your severance pay: tax strategies

When you lose your job, you have to keep a closer watch on your money. Every dollar counts. You could keep more of your severance pay by using tax planning strategies that could reduce your tax bill. Here are some examples.

• Spread out payments. Talk to your employer and ask if the severance pay can be paid to you in installments over two years, instead of as a big lump sum. Less income in one year could keep you in a lower tax bracket.

• Delay payment. If you’re due to receive a lump sum toward the end of a calendar year, ask if it could be delayed until after Jan. 1. If you’ve already earned almost a full year’s worth of wages, getting severance pay on top of that may bump you into a higher tax bracket. The severance pay may have less tax impact in the new year, especially if you end up unemployed for a while. 

• Tax breaks. You’ll want to make sure you’re taking advantage of any deductions and tax credits you qualify for, like the Earned Income Tax Credit. Deductions lower your taxable income, and credits lower your tax bill. This is one way working with a tax professional could help you.

• Plan for withholding. You might be better off asking for your severance pay to be issued as supplemental income so you ensure you don't owe taxes on it at the end of the year, as they will have already been paid. In most cases, federal taxes would be withheld from this at a flat rate of 22%. 

If you’ve prepared your own tax returns in the past, consider hiring a professional tax preparer who might be more skilled at maximizing savings. For most people, income is less stable after job loss, so it’s important to get every financial advantage you qualify for.

Common severance pay tax deductions

There are some tax deductions that could offset the amount of severance pay that's subject to income tax:

• Contribute to a health savings account (HSA) if you are eligible for one. You can make HSA contributions if you have a qualifying high-deductible health plan. These accounts allow you to save money for future healthcare expenses on a tax-advantaged basis. Your money grows tax-deferred, contributions are tax-deductible, and withdrawals are tax-free when used for qualified medical expenses. 

• A 529 college savings plan doesn't offer tax deductions for contributions, but isn't subject to taxes on investment earnings. Money used for eligible education expenses isn't taxed when withdrawn.  

• Increasing charitable donations could yield another tax deduction. This could be a way of lowering your tax bracket in the year you receive your severance. This only works if you itemize your tax deductions. 

• Boost retirement savings: If you can afford it, put some of your severance pay into a retirement account. That could lower your taxable income, with the bonus of helping your nest egg grow.

• Pay for education: New skills or credentials could help you get your next job. Education costs may be tax deductible. If you use your severance pay for school or training programs, you might not have to pay taxes on that money.

Navigating Severance Pay Taxation: Examples

You can take advantage of various strategies to lower your tax bill. Here are some examples of how people can reduce how much tax is taken out of severance pay.

A large lump-sum severance

Ruben learns in November that he’s going to be laid off before the end of the year. His employer offers him six months’ pay as a severance package to be paid as part of his last paycheck. He has already earned 11 months of wages this year. Adding his severance to his income would mean being taxed on 17 months of income this year, which would put him into a higher tax bracket. 

Worse, getting the severance added to his last paycheck could mean that withholding would be calculated as if he earned that amount every pay period. He asks his employer to pay his severance in installments over the next six months instead. This prevents him from getting pushed into a higher tax bracket this year. It also means he won’t have an unusually large paycheck that triggers a higher withholding rate.

Bump up retirement contributions

Cherise gets laid off in September, with a month of severance pay. That severance check would put her in a higher tax bracket. Rather than face a higher tax rate on her severance pay, Cherise decides to contribute that money to a traditional IRA. This allows her to defer taxes on her severance pay, avoid the higher tax rate, and give her retirement savings a boost.  

Every situation is a little different. Still, for many people, simple moves like these could save you a significant amount of taxes.

What If You Can’t Pay What You Owe?

Losing your job can put stress on your finances. It also can create an unfamiliar tax situation for you. The combination of the two may mean that come tax time, you find yourself unable to pay your taxes.

If that happens, don’t ignore the problem. If you contact the IRS for help, they may have a solution for you. They may agree to allow you to pay your taxes in installments. They may also delay when payments are due. If you absolutely have no way of paying what you owe, the IRS may agree to accept a lesser amount. If you’re up to date on filing your taxes, a new program called Simple Payment Plan helps individual taxpayers set up a payment plan online. 

If you simply ignore the problem, the IRS may be less inclined to help you find a solution. You could get hit with fines and other penalties that make the problem worse. 

Finding the right way of dealing with taxes on severance payments can do more than just save you money. It can help you start the next phase of your career without a tax problem.