Severance pay is generally considered taxable income in the United States and is subject to federal, state, and local taxes. However, with strategic planning, you can minimize the tax impact or defer some of the taxes associated with severance payments. Below are several strategies to consider:
1. Defer Severance Pay
- Explanation: Negotiate with your employer to spread your severance payments over multiple years instead of receiving a lump sum. This approach may keep you in a lower tax bracket each year, potentially reducing your overall tax liability.
- Example: If you receive severance over two or more years, the income may be taxed at a lower marginal rate compared to a lump-sum payment.
- Consideration: Not all employers may agree to this arrangement, and it may depend on company policies and your employment contract.
2. Contribute to a Tax-Advantaged Account
- 401(k) Contributions:
- If you’re still employed when severance is paid, you may be able to contribute a portion of it to your 401(k), deferring taxes until retirement.
- Contribution Limits for 2024:
- $23,000 if under age 50.
- $30,500 if age 50 or older (includes $7,500 catch-up contribution). IRS
- IRA Contributions:
- Contribute to a Traditional IRA to defer taxes, depending on your income and eligibility.
- Contribution Limits for 2024:
- $7,000 if under age 50.
- $8,000 if age 50 or older (includes $1,000 catch-up contribution).IRS
3. Deduct Eligible Expenses
- Explanation: Use severance pay to cover deductible expenses, thereby reducing your taxable income. Examples include:
- Job search expenses (e.g., resume services, travel for interviews).
- Relocation expenses, if they qualify under current tax laws.
- Health insurance premiums, including COBRA, if not reimbursed by your employer.
- Consideration: The Tax Cuts and Jobs Act of 2017 suspended the deduction for unreimbursed employee expenses, including job search and moving expenses, through 2025. However, certain moving expenses for active-duty military members may still be deductible.
4. Utilize Health Savings Accounts (HSAs)
- Explanation: If you have a high-deductible health plan (HDHP), you can contribute part of your severance pay to an HSA. Contributions are tax-deductible, and withdrawals for qualified medical expenses are tax-free.
- Contribution Limits for 2024:
- $4,150 for self-only coverage.
- $8,300 for family coverage.
- $1,000 additional catch-up contribution if age 55 or older. Forbes
5. Adjust Tax Withholding
- Explanation: Severance pay is often subject to a flat federal withholding rate of 22% for supplemental wages under $1 million. If this rate exceeds your effective tax rate, you may receive a refund when you file your return.
- Action Steps:
- Adjust your Form W-4 to withhold less from your regular income, balancing out the higher withholding on severance.
6. Consider Relocating to a Low-Tax State
- Explanation: If you are planning to move, consider timing your relocation to a state with lower or no income taxes (e.g., Texas, Florida, Nevada) before receiving your severance pay.
- Consideration: Ensure your primary residence is established in the new state before payment to avoid dual taxation.
7. Make Charitable Contributions
- Explanation: If you make deductible charitable donations, you can offset the taxable income from severance pay.
- Action Steps:
- Use a donor-advised fund to make a large contribution in the severance year while spreading out donations over future years.
8. Offset Income with Tax Loss Harvesting
- Explanation: If you have investment losses, use them to offset the taxable income from severance pay. You can deduct up to $3,000 of net capital losses per year against ordinary income.
- Action Steps:
- Consult with a financial advisor to identify opportunities for tax loss harvesting in your portfolio.
9. Evaluate Lump Sum vs. Installments
- Explanation: Opting for installment payments instead of a lump sum may spread the income over multiple tax years, potentially keeping you in a lower tax bracket.
- Action Steps:
- Negotiate with your employer for structured payments.
- Analyze your expected tax bracket for each year.
Key Considerations
- Taxable Income:
- Severance pay is subject to federal and state income taxes, Social Security, and Medicare taxes.
- State Taxes:
- State laws on severance pay taxation vary. Check your state’s tax rules.
- Consult a Professional:
- Speak with a CPA or tax advisor to develop a strategy tailored to your situation.
Summary of Strategies
| Strategy | Impact |
| Defer severance pay | Reduces taxable income in a single year. |
| Contribute to tax-advantaged accounts | Defers or avoids taxes (e.g., 401(k), IRA, HSA). |
| Use deductions | Lowers taxable income through eligible expenses. |
| Adjust withholding | Prevents over-withholding; potential refund at filing. |
| Relocate to a low-tax state | Avoids or reduces state income taxes. |
| Donate to charity | Offsets taxable income through deductions. |
By strategically managing how and when you receive your severance pay, you can minimize the associated tax burden. Always consult with a tax professional to ensure compliance with IRS regulations and to optimize your financial outcome.
Disclaimer: The information provided is for general informational purposes and should not be considered legal or tax advice. Tax laws are complex and subject to change. For advice specific to your situation, consult a qualified tax professional or refer to official IRS resources.