Severance packages provide financial assistance to employees after job loss. While this can be helpful, it is important to understand the tax implications that come with receiving severance pay. Knowing what taxes apply can help avoid surprises when tax time comes.
Severance pay is considered taxable income
The IRS treats severance payments as taxable income. This means severance pay gets added to other earned income for the year and is subject to federal, state, and local taxes. Employers typically withhold these taxes from severance payments, just like they do for regular wages. Understanding this helps employees budget accordingly.
Impact on tax bracket
Receiving severance pay may push someone into a higher tax bracket, especially if it is a large lump sum. This higher bracket means the severance payment could be taxed at a higher rate, resulting in a larger tax liability. Employees may need to set aside extra funds to cover the additional taxes if their severance pushes them into a new bracket.
FICA and other payroll taxes
Severance packages are also subject to Social Security and Medicare taxes, collectively known as FICA. Employers deduct these payroll taxes from severance payments, just as they would from a regular paycheck. Employees need to consider this when estimating how much of their severance they will take home.
Options for reducing tax impact
There are ways to minimize the tax burden of receiving severance pay. Employees may negotiate to receive payments over time instead of in a lump sum, which can help keep them in a lower tax bracket. Contributing part of the severance to a retirement plan, such as an IRA, can also help reduce taxable income.
Receiving a severance package can be both a challenge and an opportunity. Understanding the tax implications allows employees to make informed decisions that can ease the transition and help secure their financial future.