Do They Take Taxes Out of Severance Pay?

Severance pay refers to the compensation and benefits an employer provides to an employee upon the termination of their employment, beyond regular wages. This financial support is typically offered to individuals laid off or whose positions are eliminated due to company decisions, rather than performance issues. It serves as a financial bridge during a transition period, helping individuals manage expenses as they seek new employment. Severance pay is considered taxable income, meaning it has tax consequences for the recipient.

Tax Treatment of Severance Pay

Severance pay is considered taxable income by the Internal Revenue Service (IRS) and is subject to the same types of taxes as regular wages. The IRS categorizes severance pay as “supplemental wages,” which are earnings paid in addition to an employee’s regular wages.

Federal income tax applies to severance payments. Since severance is treated as wages, it is subject to federal income tax withholding based on the individual’s tax bracket. A large severance payment can increase total taxable income, impacting overall tax liability.

State income tax also generally applies to severance pay in states that levy income taxes. While specific rules and withholding rates vary by state, severance pay is typically treated similarly to regular wages for state tax purposes.

Severance pay is also subject to Federal Insurance Contributions Act (FICA) taxes, which include Social Security and Medicare taxes. Social Security tax is a fixed percentage of earnings, up to an annual wage base limit. For 2024, the Social Security tax rate is 6.2% for both the employee and employer, applied to wages up to $168,600.

Medicare tax is applied to all earned income without any wage base limit. The Medicare tax rate is 1.45% for both the employee and employer. High-income earners may also be subject to an additional Medicare tax of 0.9% on earnings above certain thresholds, which applies to severance pay.

Employer Withholding Obligations

Employers have specific responsibilities when it comes to withholding taxes from severance pay. They are generally required to withhold federal income tax, state income tax (if applicable), and FICA taxes from these payments, just as they do with regular wages. The method an employer uses for federal income tax withholding on severance pay depends on how the payment is made.

One common method for withholding on supplemental wages is the percentage method. If severance pay is identified separately from regular wages or exceeds certain thresholds, employers may apply a flat federal income tax withholding rate. For amounts up to $1 million, the flat withholding rate is typically 22%.

Alternatively, employers might use the aggregate method if severance pay is combined with regular wages or if certain conditions are met. Under this method, the employer adds the severance pay to the employee’s regular wages for the most recent payroll period. They then calculate the income tax withholding on the combined amount as if it were a single payment. The tax already withheld from regular wages is then subtracted to determine the withholding for the severance portion.

Regardless of the method used, the employer is responsible for accurately calculating and withholding taxes, then remitting these funds to the appropriate tax authorities. Employers will report the severance pay and taxes withheld on the employee’s Form W-2, Wage and Tax Statement, for the year the payment was made.

Individual Tax Reporting

Individuals receiving severance pay have specific responsibilities when reporting this income on their tax returns. The severance payment, along with any taxes withheld by the employer, will be included on Form W-2, Wage and Tax Statement. Total severance pay is typically combined with other wages and reported in Box 1 (Wages, tips, other compensation).

FICA wages, including severance pay subject to these taxes, will appear in Box 3 (Social Security wages) and Box 5 (Medicare wages). Individuals should review their Form W-2 to ensure all reported amounts and withholdings are accurate, addressing any discrepancies with their employer before filing.

When preparing their U.S. Individual Income Tax Return (Form 1040), individuals use the information from their Form W-2 to report total income. Severance pay, already included in Box 1 wages, contributes to the individual’s gross income for the tax year and is subject to progressive federal income tax rates.

A substantial severance payment can affect an individual’s tax bracket for the year, as it increases total taxable income. This may result in a higher overall tax liability if withholding was insufficient. If the tax withheld from severance pay and other income sources is not enough to cover the total tax liability, individuals might face an underpayment penalty. Reviewing one’s overall tax situation after receiving a large lump sum like severance is advisable to determine if estimated tax payments are necessary to avoid penalties.