Entrepreneurship is all about facing different (sometimes unpredictable) circumstances and taking calculated risks.
Among several situations, it might be so that you have to lay off several employees or shut down a process due to financial constraints. In such a situation, the main question arises about a severance package.
Several questions surround severance pay or benefits like it is; is severance pay taxable, etc. So, to get a detailed understanding of severance pay and severance pay taxes, read on!
What Is Severance Pay?
Severance pay is the compensation or benefits employees receive when terminated or laid off from an organization. The employer might pay it as a lump sum or benefits like insurance.
Severance pay is generally based on how long the employee has worked in the organization. Employers provide the severance pay or benefits as a token of gratitude and to ensure financial support for the employee until their next job.
Though you might provide severance pay, it is not a federal requirement under the Fair Labor Standards Act. It is taxable, and the severance amount is subject to payroll taxes like regular wages and additional taxes that we will discuss later in this blog.
Why Should Employees Know about Severance Pay Taxes?
Ask employees if they know about severance pay taxes. Not many will know about it. But employees need to know about severance pay taxes along with employers.
That’s because understanding severance payments will allow them to negotiate for a higher severance package. When employees know about severance pay taxes, they can negotiate and work for a higher severance package.
Therefore, even after paying severance taxes, they will have a sufficient amount in hand.
How is Severance Pay Taxed?
Employers often get stuck with the ‘Is severance pay taxable?’ question. Hence, it is important to get detailed information on severance pay taxes.
First off, severance pay is taxable. You must pay FICA taxes on the severance amount. Let’s get into the how and why.
Generally, each employer and employee pays 6.2% Social Security taxes on employee compensation. Plus, 1.45% Medicare taxes are also levied on all wages. That makes a total of 15.3% tax up to the yearly cap.
These taxes together make the payroll, FICA, or employment taxes. The employer withholds employee compensation, adds the employer percentage, and sends it to the IRS.
You might say that FICA taxes are applicable on employee wages only. Since severance payments are received termination, the employee becomes a former one. Hence, you might think that severance is not a part of employee wages.
But according to the United States Supreme Court, severance payments are wages. They are subject to FICA taxes. Severance payments are provided to employees as remuneration until they find a suitable job.
Additionally, severance payments are also considered ‘supplemental wages’ that have their tax policies. Employers must withhold income tax from severance payments at a flat severance pay tax rate of 22%. State income taxes must also be withheld in the 43 states with income taxes.
Remember these severance pay tax rules. Employees might negotiate the gross severance amount so that the taxes get covered. Though you might not agree to pay higher severance, you can agree too, depending on the circumstances within your organization.
For employees, calculating the gross-up amount is also important. They can do it by adding the percentage amounts of all due taxes,
- Federal income tax
- State taxes
- FICA (employee’s share of 7.65% up to annual cap)
Minus this percentage from 100% and divide the base severance pay by the obtained result.
Let’s see an example. Suppose an employee’s base severance pay is $50000. The total employee FICA, state tax, and income tax due on the severance payment is 40%. Then, minus 40% from 100%. You have 60%. Now, divide $50000 by 60%. It results in $83333. Thus, employees can demand $83333 to get $50000 in hand after taxes.
How to Minimize Taxes on your Severance Pay?
Though you must pay severance pay taxes, there are a few ways to minimize tax on severance pay.
Here’s is a list of these ways. Let’s explore!
Save for retirement
If you are thinking about reducing taxes on severance pay, then one of the many ways is contributing to a retirement plan.
To pay fewer taxes on severance pay, you can contribute towards an individual retirement account.
As of 2022, you can contribute up to $6000 annually if you are under 50 to an IRA. If you are 50 or older, you can save up to $7000. These retirement savings are not taxed until withdrawal.
You can also save your funds in a Roth IRA. This money will be taxable when you deposit not on withdrawal. Either way, IRAs can ensure minimizing your severance pay taxes.
Besides IRAs, you can also contribute towards your employer’s 401(k) plan. The 401(k) plan has a yearly limit of $20500 as of 2022 and an additional boost of $6500 for people over 50 years.
Spread out your severance pay
If you time your payout, you can minimize taxes on severance pay. Ask your employer to spread out your severance payment in two years instead of providing the lump sum in a year. Taking the entire amount in one year might result in a huge tax hit.
Staggered severance payments can reduce your tax bracket and the corresponding tax rate.
Pay for education
Contributing to a 529 plan can help you reduce your severance pay taxes. So, if you have a nephew, niece, or any kids, you can consider using your severance pay to invest in a 529 plan. This investment might even get you some state deductions.
Often parents use this way of tax-advantaged savings to ensure saving for their children’s education. Though the rules for this savings plan might be different by state, the earnings are not subject to income taxes.
Make sure you read the savings plan rules carefully to check the savings limits.
Go for a donor-advised fund
Another way to minimize tax on severance pay is to invest in a donor-advised fund. This is a unique way to reduce your severance pay taxes. Using a donor-advised fund, you can offset the severance pay taxes.
The best thing about a donor-advised fund is that the fund allows a person to get the tax benefit. Also, the person holds the right to say how an organization receives the funds.
Use it for health expenditures
Putting away your severance pay in a health savings account is another amazing way to plan for future expenses while reducing severance pay taxes. You might use high-deductible health insurance plans to save your severance payment.
As of 2022, you can save as much as $3650 for self-coverage or opt for the maximum of $7300 in case of family plans. Here, the deductible would be more than $1400 for self-coverage or $2800 for family coverage.
Also, there might be some other expenses, a maximum of $7050 for self or $14100 for family coverage.
How does Severance Pay affect Unemployment?
After termination, several employees receive unemployment benefits. But these unemployment benefits are also taxable.
Though it seems unfair, the recipients of unemployment benefits in California must pay FICA taxes. However, they do not need to pay state income taxes.
As an employer, you might offer unemployment benefits to employees after termination. Generally, employees are eligible to collect their unemployment benefits after termination. But if an employee is terminated for serious misconduct, they will not be eligible for unemployment benefits, either entirely or for a limited period.
In many states, unless the employee’s misconduct can be rendered as pretty bad, they will be eligible for benefits. The reasons like lack of necessary skills, not performing up to standards, etc. do not make an employee ineligible for benefits after termination.
- Violating safety standards and rules
- Theft
- Crime
- Failing alcohol or drug test are a few of the reasons why an individual might be ineligible to collect unemployment benefits
The provisions for severance pay are different in different states. Also, whether severance payment will affect unemployment benefits or not depends on the state law.
For instance, in California, severance payment does not impact unemployment benefits regardless of the payment being received in a lump sum instead of installments. You are to pay taxes on the total amount like any other income. But it will not be deducted from your unemployment benefit.
In New York, if you receive the same benefits after termination as you were receiving while working, you will not be eligible for unemployment mostly. But you will be able to claim unemployment benefits if your weekly severance pay is less than the maximum unemployment insurance rate per week.
Further, in Texas, the severance payment might delay or stop receiving unemployment benefits. Payments will be delayed until the period of coverage for the payment has expired.
So, because the state laws and circumstances vary, you must check with the state department of labor to understand the rules that will determine whether you qualify or not.
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