Taxes on Severance Payments
Companies often offer severance payments after firing or letting an employee go, and the amount can vary. Severance pay can range from a few weeks to a few months of salary. Generally, the higher an employee’s salary, the more severance pay they can expect to receive. Some companies also consider an employee’s rank within the company hierarchy when deciding how much to pay them. Regardless of the amount, severance payments are subject to the same federal income tax rules as regular wages, and employees should understand how their severance packages are taxed before they leave their jobs.
Severance pay may include a lump sum payment or a series of installments, and the method used to calculate the payment’s tax liability can be different. For instance, some employers might use a formula to gross up the total severance package so that it is evenly distributed. A formula may factor in the employee’s yearly earnings and tax bracket, as well as any applicable state or local taxes. Another option is to use a percentage-based system, which involves adding a fixed percentage of the total severance package to each installment. This method can be beneficial if an employer does not have the resources to gross up the entire severance payment in one lump sum.
The IRS says that severance pay is taxable the year it is received, and an employee’s former employer should withhold payroll taxes, such as federal income tax (FUTA), Social Security tax and Medicare tax, in the same way that they would with a regular paycheck. These taxes should be included in the total reported on the former employee’s Form W-2 for that year.
Taxes on Severance Payments After Job Loss
Some states have their own severance pay laws, and these differ from federal law. For example, some states might not tax severance pay at all, while others may only tax it if the employee received it because they were fired rather than laid off, says attorney Clark. It is important for both employees and employers to know their state-specific define severance pay laws to avoid any legal complications.
In addition to severance pay, companies can provide other items in a severance package. These might include continued health insurance, career consultation services or a payout of unused vacation and sick time. Some companies might even let an employee keep company equipment, such as a laptop or cell phone.
While severance pay can help people bridge a gap in their income, it is not a substitute for a reliable source of income. Before leaving a job, it is best to have built up a substantial emergency fund and a cushion for unforeseen expenses. A Northwestern Mutual financial advisor can make recommendations for establishing these funds so they are sufficient to cover a job loss and other unexpected financial events.
At its core, severance pay acts as a form of compensation to ease the immediate financial strain on employees during their transition period. Losing a job can be a jarring experience, often accompanied by uncertainty about future employment prospects and financial stability. Severance pay provides a buffer, offering employees a temporary source of income to cover expenses such as rent, groceries, and bills while they search for new opportunities.
