Severance pay often comes into play when an employee must part ways with a company, whether due to layoffs, restructuring, or retrenchment. As an employer or HR professional, a critical point to understand is the tax organization of severance packages. Taxation is complex, yes, but severance pay taxation takes it a notch higher, influenced by federal, state, and even local tax regulations, as well as any special agreements subjected to you and your employees.
So, severance pay — is it taxable? What are the regulations around withholding and deductions? More importantly, how can you, as an employer, be able to process severance pay tax to avoid possible compliance risk yet bring clarity and reasonability to your employees?
This article explores the ins and outs of severance package tax, from severance pay tax rates to payroll deductions, and outlines why tools like Multiplier’s Global Payroll solution can make these processes more efficient.
Why understanding severance pay taxation is important
Severance pay is not simply a courtesy but often a critical aspect of the employer–employee relationship during termination. Ensuring that severance pay deductions are handled correctly is vital for compliance with tax laws and maintaining a positive experience for departing employees.
Severance pay is generally classified as additional income, and hence not taxed the usual way. It is liable to taxation under both income taxes and payroll taxes. Getting a hang of these details is key to avoiding compliance issues and making sure that your employees don’t face a negative experience when tax season comes.
Why does this matter?
Handling severance incorrectly can result in under- or over-withholding, which could lead to penalties for your company or a disgruntled former employee getting hit with an unexpected tax bill. Worse, failure to handle severance tax well may leave your organization exposed to audit risks from tax authorities.
For example, let’s take John, an employee in New York City. After a layoff, he gets a severance package of $50,000. Because of NYC’s local taxes coupled with the state and federal taxes, the overall amount withheld from his severance pay is higher than it would be if he lived in a state with low/no local income tax. Without the proper tax calculation and withholding, John could owe a significant amount during tax season, leading to frustration and stress for both him and the employer.
With a global workforce, there are additional issues. As severance payment could be meted out in multiple currencies, it is subject to other socioeconomic factors such as tax rates, thresholds, and local deductions, too.
This is where a tool like Multiplier becomes invaluable, allowing you to run compliant payroll, including severance payments, while running global operations.
Severance package tax rate and withholding
When managing severance pay tax rate, you need to understand the federal laws and the respective state laws, and any other local obligations to avoid under- or over-withholding.
Follow these points to better understand these obligations:
1. Federal tax rates on severance pay
When the time for severance pay comes, the Internal Revenue Service (IRS) considers it as additional income, similar to bonuses or commissions. The Federal income tax on severance pay can be calculated by incorporating either of the two alternatives:
- Flat rate method: The IRS requires employers to withhold 22% of the severance payment as a flat rate, which is applicable to all additional wages. For example, if you offer Adrian $20,000 as severance paymea nt, then $4,400 would be given to the IRS as income tax for the period.
- Aggregate method: This method groups the severance pay with the employee’s last paycheck and calculates the usual payroll tax on severance pay using the regular income tax brackets. In this situation, it might raise the employees’ taxation proportions to much higher levels, resulting in them withholding more money than they did previously.
Most companies tend to use the flat rate method because it makes the calculation easy and fast, ensuring consistency in payments and with fewer potential complications.
Nonetheless, it is necessary to emphasize that the severance pay tax rates at the federal level may be regarded differently with severance pay at the state or local levels. These rates may change from region to region, which leads us to the next point.
2. State and local taxes on severance pay
State and local tax laws add another layer of complexity to severance pay. Every state can set its own income tax on severance pay. For instance:
- California: Severance pay is subject to the state’s progressive income tax rates, meaning the higher the severance, the more the withholding tax.
- New York: Both state and New York City local taxes apply to severance pay, meaning employees within city premises can be subject to higher withholding compared to those outside.
- In contrast, states like Florida and Texas, which don’t have a state income tax, make it simpler for employers, as no state taxes are withheld from severance payments.
Let’s understand this better through an example: Imagine an employee in California receiving a severance of $100,000. In addition to the 22% federal withholding, California’s state tax rate can reach as high as 13.3%, depending on the employee’s total income. As a result, an additional $13,300 could be withheld for state taxes, significantly reducing the net amount the employee takes home.
In comparison, an employee in Texas receiving the same $100,000 severance would only have federal taxes withheld, as Texas does not have a state income tax. In this case, the employee’s net severance would be significantly higher.
3. Employer withholding responsibilities
The tax procedures that relate to your employee’s severance payment rest solely on your shoulders. Tax withholding in this case has to be balanced by achieving what would meet you and your employee’s needs. Too much taxation may result in very little severance for the employee after taxation, which may bring forth dissatisfaction as well.
Tools like Multiplier’s payroll platform can make this easier for HR teams by automatically calculating and withholding the right amount of tax for severance pay, regardless of where your employees are located.
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Severance pay deductions and payroll taxes
Given below are some of the key severance pay deductions and payroll taxes, let’s have a look:
1. Payroll taxes on severance pay
Along with regular income tax, severance pay is also subject to certain other taxes, such as payroll tax. This includes:
- Social security taxes: In 2024, the social security tax is 6.2% for both the employer and the employee but limited to a maximum wage of $160,200. Severance payments are counted toward this cap, so if the employee’s severance pushes them over the limit, Social Security taxes will no longer apply.
- Medicare taxes: Medicare taxes apply to all wages, including severance pay, at a rate of 1.45% for both employers and employees. Further, an extra tax of 0.9% would be paid by employees whose compensation exceeds $200,000 as a Medicare surtax.
These taxes can significantly reduce the amount of take-home severance, which is also the reason both employers and employees should be aware of their effects on the final pay.
2. Common deductions from severance pay
In addition to payroll taxes, certain other deductions can also be imposed on severance payment. Depending on your company policies and the agreement with the employee, you may need to deduct retirement contributions and health insurance premiums.
- Retirement contributions: A few severance packages generally permit employees to make retirement contributions such as 401(k) or pension plan contributions even after discontinuing employment. These deductions are typically pre-tax, hence lowering taxable income.
- Health insurance premiums: If, for example, you receive a severance and continue with health benefits under COBRA, then health insurance premiums may also be subject to such deductions.
It is highly important to inform your employees about these deductions clearly so that they are knowledgeable of the net pay after paying tax and other deductions.
Common misconceptions about severance pay taxes
Misconception 1: Severance Pay Is Free From Tax
Some employees may think of severance pay as an untaxable unit on their paystub. However, severance benefits are usually not free from taxation.
Misconception 2: You Can Always Spread Severance Over Multiple Years
While some employees may prefer to spread out severance payments over time to reduce tax burden, severance is usually issued as a one-time payout. In fact, some states in the U.S. have strict regulations for termination and severance.
Misconception 3: Severance is exempt from payroll taxes
In reality, severance pay is subject to the same payroll taxes—like Social Security and Medicare—as regular wages. This means that payroll tax on severance pay must be deducted even if the employee is no longer actively employed.
Severance pay taxes: Key takeaways
Severance pay taxes can be tricky, especially for employers managing a dispersed or international workforce. However, employers can follow some best practices to ensure that the process is as smooth and compliant as possible:
- Use the Right Tax Withholding Method: The flat rate method is often simpler and less likely to result in significant under- or over-withholding compared to the aggregate method.
- Automate payroll deductions: Platforms like Multiplier help streamline payroll tax calculations for severance pay, without the fear of making wrong payroll tax returns.
- Stay compliant across jurisdictions: Every state—and in some cases, regions and cities within states—have constituted their own tax rules. Using a payroll system that can automatically adjust for local taxes ensures that you’re compliant wherever your employees are based.
Pro tip: Using a severance pay tax calculator helps make the process easier and quicker.
When it comes to severance pay it is not only a matter of legal compliance, it is about protecting how your employees feel about their separation.
Case Study: Cross-Border Severance Pay Taxation
This cross-border case study provides an in-depth examination of the complexities of severance package taxation.
Scenario:
A company registered in the United States terminates an employee based in Germany. Under the severance agreement, she would receive a lump sum severance equivalent to three months’ salary.
Tax Implications in the U.S.:
The severance payment would be considered additional income and would attract a flat 22% withholding rate for federal tax, along with any applicable state taxes (depending on the state). Social Security and Medicare taxes would also be applicable, subject to wage limits.
Tax Implications in Germany:
Severance payments are taxable in Germany because they form part of the employee’s wages; however, they are entitled to relief under income tax’s fifth rule (Fünftelregelung). This rule provides that, for tax purposes, the severance payment is only recognized over a period of five years, thus lowering tax liabilities to the employee. Additionally, in Germany, there are no payroll taxes (social security) levied upon severance pay.
Using a good payroll software solution, the organization will be able to accurately determine tax withholdings based on the respective employees’ locations and comply with both U.S. and German tax requirements.
Simplifying severance pay with Multiplier
Severance pay taxation is complex, involving multiple tax jurisdictions and unique circumstances for each employee. As an employer, it’s critical to ensure that taxes are withheld correctly and that you are following all federal, state, and local regulations.
Multiplier makes managing severance pay easy by automating the tax calculations and ensuring compliance in every country where you employ workers. With its global payroll platform, you can handle all aspects of severance pay—taxes, deductions, and reporting—without the risk of error.
Don’t allow severance pay taxes to stand in your payroll processes.
Find out more about using Multiplier to optimize global payroll in your organization.
FAQs
Q. How is severance pay taxed differently from regular wages?
Severance pays are regarded as additional or secondary incomes and have tax withholding that is different from normal salaries. For federal tax withholding, a good proportion of the salary, i.e., 22% flat rate, is typical. Although the rate changes if the aggregate method is applied.
Q. What should I do if I think too much tax was withheld from my severance?
Employees can claim a refund for over-withheld taxes when filing their annual tax returns. If your employees raise concerns about withholding, make sure they consult with a tax professional.
Q. Can I spread severance pay over several years to reduce my tax burden?
Severance payments can be spread over several years to lessen the proportion to be paid in taxes but it is most often paid as a lump sum. Nevertheless, tax consultants may suggest other ways in which employees can protect themselves from the adverse effects of large payouts.
Q. Are there any tax exemptions or special rules for severance pay?
In exceptional instances, it may be possible to obtain severance payment exemption, when they are part of a lawsuit settlement. However, it is recommended to always verify with a tax advisor if there are any chances for exemption.
