Does Severance Pay Affect Social Security?

Severance pay, a common compensation upon employment termination, raises questions about its interaction with Social Security benefits. This payment, typically offered for reasons other than cause, serves as a financial bridge during career transitions. Many wonder how receiving such a payment influences Social Security contributions and future or current benefits. Understanding how severance pay is treated by the Social Security Administration (SSA) and the Internal Revenue Service (IRS) is important for financial planning during employment changes.

Severance Pay and Social Security Taxes

Severance pay is generally classified as “wages” for Federal Insurance Contributions Act (FICA) tax purposes, encompassing Social Security and Medicare taxes. Both the employee and employer must contribute a percentage of the severance amount to the Social Security system, similar to regular earnings. The U.S. Supreme Court has affirmed this classification, confirming severance payments are subject to FICA taxes.

For 2025, the Social Security tax rate is 6.2% for both employee and employer, totaling 12.4% on wages up to the annual wage base limit. This limit is set at $176,100 for 2025, meaning earnings above this amount are not subject to the Social Security portion of FICA tax. The Medicare tax has no wage base limit; it applies to all covered earnings at a rate of 1.45% for both employee and employer, totaling 2.9%. These taxes are typically withheld directly from the severance payment by the employer.

How Severance Pay Contributes to Your Earnings Record

Once subject to FICA taxes, severance pay contributions are recorded as part of an individual’s lifetime earnings history by the Social Security Administration. This earnings record determines eligibility for Social Security retirement, disability, and survivor benefits. Each year, individuals can earn up to four Social Security work credits.

In 2025, earning $1,810 in FICA-taxed income, including severance pay, grants one work credit. To acquire the maximum four credits for the year, an individual needs to earn $7,240. These credits accumulate over a person’s working life and are necessary for meeting benefit eligibility. Most individuals need 40 credits, equivalent to 10 years of work, to qualify for retirement benefits.

Severance Pay and Future Social Security Benefits

Severance pay in an individual’s earnings record can positively influence the calculation of future Social Security retirement or disability benefits. The Social Security Administration uses a formula considering a worker’s Average Indexed Monthly Earnings (AIME) to determine their Primary Insurance Amount (PIA). AIME is derived from the 35 highest-earning years, with past earnings adjusted for inflation to reflect current wage levels.

Severance pay, by adding to FICA-taxed earnings for the year received, can contribute to a higher overall AIME. A higher AIME generally results in a higher PIA, which translates into larger monthly retirement or disability benefit payments in the future. Therefore, severance pay does not diminish future benefits; instead, it can enhance them by strengthening one’s earnings history.

Severance Pay and Current Social Security Benefit Payments

For individuals already receiving Social Security benefits, especially those claiming retirement benefits before their full retirement age (FRA), severance pay can have direct implications due to the Social Security Earnings Test. If an individual is under their FRA for the entire year, benefits may be reduced if annual earnings exceed a certain limit. In 2025, this limit is $23,400, and $1 in benefits is withheld for every $2 earned above this threshold. For those reaching their FRA during the year, a higher earnings limit applies ($62,160 in 2025), with $1 in benefits withheld for every $3 earned above this amount until FRA is attained. Severance pay is considered earned income for this test, which can lead to a temporary reduction or suspension of benefits if the payment pushes total earnings above the specified limits.

For individuals receiving Social Security Disability Insurance (SSDI), severance pay may also be relevant to the Substantial Gainful Activity (SGA) rules. The SSA defines SGA as work activity involving significant physical or mental activities performed for pay or profit. If severance pay is considered income indicating an ability to perform SGA, it could affect continued disability eligibility. For non-blind individuals in 2025, the monthly SGA limit is $1,620, while for blind individuals, it is $2,700. Exceeding these limits through severance or other earned income could prompt a review of disability status.