Is Severance Pay Eligible for 401k Contributions?

Severance pay, often provided to employees upon termination, raises questions about its treatment in retirement savings plans. Understanding whether severance payments qualify for 401k contributions is important for both employers and employees aiming to optimize retirement benefits.

How Severance Differs From Regular Pay

Severance pay and regular pay serve distinct purposes and are treated differently in financial contexts. Regular pay compensates employees for their work and is subject to standard payroll processes, forming the basis for calculating benefits like Social Security and Medicare taxes. It is also the primary source for 401k contributions, often through automatic deductions.

Severance pay, on the other hand, is a one-time payment or series of payments provided upon termination to compensate for the loss of employment. The IRS categorizes severance as supplemental wages, subjecting it to a higher withholding rate of 22% as of 2024 unless the employer uses the aggregate method. Its eligibility for retirement plan contributions depends on the terms of the employer’s plan. Some plans allow severance to count as eligible compensation for 401k contributions, while others do not. Employees should consult their employer’s plan documents or financial advisors for clarity.

Employer Discretion on 401k Severance Contributions

The inclusion of severance pay in 401k contributions is determined by the employer and the provisions of their retirement plan. Employers outline what qualifies as eligible compensation in their plan documents, and this can vary. The Internal Revenue Code does not require severance pay to be included, leaving the decision to the employer.

Employers choosing to allow severance pay for 401k contributions must amend their plan documents to reflect this. These updates must comply with the Employee Retirement Income Security Act (ERISA) and other regulations and be communicated clearly to participants to avoid confusion or legal issues.

For employees, understanding their employer’s policy on severance pay contributions is critical. If severance is eligible, employees can plan accordingly. If it is not, alternative saving strategies may be needed. Reviewing the employer’s Summary Plan Description (SPD) or consulting HR can provide clarity.

Contribution Caps for Severance Funds

Contribution limits set by the IRS apply to all 401k contributions, including those from severance pay, if allowed. For 2024, employees under 50 can contribute up to $23,000, while those 50 and older can add an additional $7,500 as a catch-up contribution. These caps cover the total of all contributions made to the 401k plan within a year.

Severance pay, typically disbursed as a lump sum, poses timing challenges for contributions. A large severance payment could quickly reach the annual contribution limit, requiring employees to carefully plan how much to allocate. Employers may need to work with employees to structure payments in a way that aligns with contribution goals.

Employer matching contributions can also be affected. If severance pay qualifies as eligible compensation, it may count toward matching contributions. However, matching policies vary, and employees should verify with their HR department how severance contributions are treated.

Tax Withholding on Severance Contributions

Tax withholding on severance contributions is influenced by how severance pay is classified. The IRS treats severance as supplemental wages, applying a flat withholding rate of 22% unless the aggregate method is used. This rate can reduce the net amount available for 401k contributions.

The timing of severance payments adds complexity. Lump-sum payments are subject to immediate withholding, potentially limiting the amount an employee can contribute to their 401k. Employers may use the aggregate method, which combines severance with regular wages for withholding calculations, potentially resulting in a more favorable tax outcome.