How Is Severance Pay Taxed? A Detailed Breakdown
Understand the nuances of severance pay taxation, including federal and state guidelines, and its impact on your tax bracket.
Understanding how severance pay is taxed is crucial for individuals navigating a job transition. Severance packages, typically offered during layoffs or terminations, come with various tax implications that can affect financial planning.
This article examines the taxation of severance pay, focusing on federal and state guidelines, Social Security, Medicare, and payment structures.
Federal Income Tax Guidelines
Severance pay is subject to federal income tax as supplemental wages. The IRS allows employers to use one of two withholding methods: the aggregate method or the percentage method. The aggregate method combines the severance pay with the employee’s most recent regular paycheck, calculating withholding based on the total. The percentage method applies a flat withholding rate of 22% to the severance pay.
The choice of method influences the net amount an employee receives. A substantial severance package under the aggregate method could temporarily place the employee in a higher tax bracket, increasing withholding. Meanwhile, the percentage method offers a flat rate, creating more predictable withholding. Employees should discuss these options with their employer or tax advisor to make informed decisions.
In addition to federal income tax, severance pay is subject to Social Security and Medicare taxes. These are withheld at standard rates of 6.2% for Social Security and 1.45% for Medicare in 2024, just as with regular wages.
State Income Tax Variations
State income taxes on severance pay vary widely. States like Florida and Texas do not impose income taxes, while others, such as California and New York, have progressive systems that could increase tax liability for larger payouts. Understanding state-specific rules is essential for accurate tax planning.
For example, California taxes severance pay as ordinary income, with rates ranging from 1% to 13.3% in 2024. A large severance package might push an individual into a higher bracket. In contrast, Pennsylvania applies a flat income tax rate, simplifying calculations. Some states, like New York, require employers to withhold state income tax from severance pay, mirroring the treatment of regular wages. Additionally, reciprocity agreements in certain states, such as Illinois, may affect tax obligations for individuals working across state lines.
Social Security and Medicare
Severance pay is subject to Social Security and Medicare contributions, ensuring continued funding of these programs during employment transitions. The Federal Insurance Contributions Act (FICA) mandates these withholdings. In 2024, the Social Security tax rate remains 6.2%, with a wage cap of $160,200. Income above this threshold is exempt from Social Security tax. The Medicare tax rate is 1.45% and applies to all earnings without a cap.
High earners should also consider the Additional Medicare Tax of 0.9%, which applies to wages exceeding $200,000 for single filers or $250,000 for joint filers. Employees receiving significant severance packages must track their total income to determine if this additional tax applies.
Lump-Sum vs Periodic Payouts
The choice between a lump-sum severance payment and periodic payouts carries financial implications. A lump-sum provides immediate access to the full amount, which may be useful for addressing urgent expenses or investments. However, the sudden increase in taxable income could trigger higher tax liabilities, potentially pushing an individual into a higher tax bracket.
Periodic payouts, distributed over several months or years, offer a steadier income stream. This structure may align with prior salary levels and help manage day-to-day expenses. Additionally, spreading income over multiple tax years can help avoid higher tax brackets, reducing overall tax liability.
Tax Bracket Implications
The timing and structure of severance pay affect tax brackets. A lump-sum payment could significantly increase taxable income, potentially placing an individual in a higher tax bracket. For example, someone in the 24% federal tax bracket might temporarily move into the 32% bracket due to the additional income, increasing both federal and, in states with progressive systems, state tax liabilities.
Periodic payouts can mitigate this risk by spreading income across multiple periods, helping to maintain a consistent tax rate. This approach may also preserve eligibility for certain tax credits or deductions. Tax advisors often recommend this strategy to manage tax exposure effectively.