Is Severance Pay Considered Earned Income for Tax Purposes?

Severance pay is a financial cushion provided to employees upon termination, often serving as a bridge during career transitions. Its classification for tax purposes carries significant implications for both individuals and employers, influencing how it is reported and taxed. Understanding its relationship to earned income is key to clarifying its impact on tax obligations and government benefit eligibility.

Federal Tax Classification

Severance pay is categorized as supplemental wages under the Internal Revenue Code (IRC), which determines its taxation and reporting requirements. Like regular wages, it is subject to federal income tax withholding, Social Security, and Medicare taxes. The IRS provides two withholding methods: the aggregate method and the percentage method. As of 2024, the percentage method applies a flat 22% withholding rate for federal income tax.

Employers must report severance pay on the employee’s Form W-2, listing it in Box 1 as wages, tips, and other compensation. Proper reporting is critical, as it affects an employee’s taxable income and tax liability. Errors in classification or reporting can trigger audits or penalties.

Withholding Requirements

The withholding process for severance pay follows specific IRS guidelines. The aggregate method combines severance pay with the employee’s most recent paycheck, which may result in higher withholding by temporarily placing the employee in a higher tax bracket. Alternatively, the percentage method applies a flat 22% withholding rate, offering a straightforward approach.

Employers must also account for state and local tax regulations, which vary widely. For example, California imposes a 6.6% flat withholding rate on severance pay, while New York applies a rate of 9.62%. Adhering to these rules is essential to avoid compliance issues and penalties.

Government Benefit Eligibility

Severance pay can affect eligibility for government benefits like unemployment benefits and the Supplemental Nutrition Assistance Program (SNAP). Many states treat severance as income, which can delay or reduce unemployment benefits. Some states impose a dollar-for-dollar reduction, while others disqualify applicants during the severance period.

For SNAP, eligibility is determined by income thresholds, and severance pay may temporarily raise an individual’s income above the qualifying limit. The payment structure also plays a role. Lump sums might affect a single month’s benefits, while installment payments could impact eligibility over several months.