Severance Pay and Taxes: What Employees Must Know to Avoid Financial Surprises

During a time when many companies, including those in the rapidly-growing tech industry, have conducted layoffs, workers need to know their rights and responsibilities. Unfortunately, mass layoffs have happened at many employers from Twitter to Google over the past year. If you received financial compensation after being terminated from your job, you're probably wondering whether severance pay is taxable.

You might be hoping that since severance is somewhat of a financial consolation for the larger issue of losing your job, Uncle Sam would leave that income alone. However, no such luck. Severance income is viewed the same way by the government as the income from performing your job, and therefore it's taxable. Keep reading for all the details.

Severance pay, or money paid by an employer to a laid-off employee, is usually calculated based on the amount of time you may have worked for that company. Not all companies pay severance after letting employees go, but if you're among the lucky ones to be fired with severance, you need to know how that impacts your taxes.

For someone who has received a severance package (for instance, six weeks worth of your regular salary), you will have to pay taxes on that income. The IRS states that severance income is taxable in the year it was received. So, if you received severance checks in 2022, your 2022 tax returns filed in 2023 must include that information.

Severance pay is taxed as ordinary income by the IRS. Employers will withhold taxes on the payments (much like they do on your salary payments) and include those amounts on the employee W-2 for that tax year. Like unemployment benefits, severance is subject to taxation (though unemployment had some exceptions due to the COVID-19 pandemic).

While you can't completely avoid paying taxes on severance income, there are strategies you can use to minimize the tax you'll owe. Putting some or all of your severance money into a HSA or IRA can reduce your tax bill. You might also request to receive your severance in two different years.

Other ways to minimize taxes include putting the severance money into a 529 plan for educational expenses or supporting a charity with a donor-advised fund.

Using some of your severance pay (if you don't need it for living expenses) to fund a retirement account can minimize any tax you owe. Put some of the money into an individual retirement account (IRA) if you haven't met your contribution limit for the year. Some employers may allow you to funnel it into a 401(k).

While you can put your severance pay into a health savings account, it won't benefit you if you need it to live on. But, if you can afford it and have a high-deductible health insurance plan, you could put some of your severance towards a health savings account (HSA). For 2023, the maximum for an individual is $3,850 and maximum for a family is $7,750 if your deductible and out-of-pocket maximums qualify.

If you're getting severance in a lump sum, consider the amount and whether it could affect your tax bracket for the year in which you receive it. A strategy for minimizing taxes, especially for a large severance deal, is to request payment in two different years. Your employer might give you the severance pay in two separate payments. That enables you to keep taxable income lower for each year.

A lump sum on its own isn't a bad idea. It's taxed using the ordinary income tax brackets. However, large severance payments could cause part of the money to be taxed at a higher rate than your usual paychecks.