Is Severance Pay Taxable? A Guide to Severance Pay Tax Rates

If you are laid off or fired from your job or quit, you may be entitled to severance pay. You may also receive a severance package if you sue or settle with a company.

Severance checks can come months and, in some cases, years after an employee has left a company, opening up questions about whether such payments are subject to taxes.

So, is severance pay taxable? What is the severance pay tax rate? And are there any ways to reduce severance package taxes?

Severance Pay Taxes Explained

Is severance pay taxed? In short, yes. But to gain a fuller understanding, let’s start with the fundamental question: what is a severance tax? 

Severance checks, along with unemployment compensation and payments for accrued sick days and vacation time, are all considered taxable income under IRS regulations. This means they are subject to withholding and employment taxes just like any other paycheck. 

If you receive your check on exit, you may find severance pay taxes have already been accounted for, along with other regular payroll deductions. If your severance pay comes later down the line as a gross check, you are required to report it when you file your tax returns. Either way, severance pay tax is an unfortunate inevitability. 

Severance Pay Tax Rates

So, exactly how is severance pay taxed? 

The IRS classes severance pay as supplemental wages for income tax withholding. Taxes are due in April of each year, although it’s sometimes possible to apply for an extension until October. 

You should expect deductions to cover Social Security and Medicare Tax, Federal Unemployment Tax, Federal Income Tax, and State Income Tax:

1. Social Security Tax 

Social security tax is charged at 12.4% and split equally between the employee and employer at a rate of 6.2% each. Social Security taxes fund retirement, disability, and survivorship programs regulated by the Social Security Administration.

2. Medicare Tax

Medicare tax is charged at 2.9% and split equally between the employee and employer at a rate of 1.45% each. Medicare taxes fund hospital, hospice, and nursing home costs for disabled and elderly Americans. 

3. Federal Unemployment Tax 

Your employer pays federal unemployment tax at a rate of 6% on the first $7,000 paid to each employee as wages during the year. Unemployment tax funds are allocated to state unemployment insurance agencies and used to provide benefits to people who are out of work. 

4. Federal Income Tax Withholding 

Deductions are based on your tax bracket and filing status. For the 2023-24 tax year, there are seven federal tax brackets: 10%, 12%, 22%, 24%, 32%, 35% and 37%. The thresholds for income tax vary depending on whether you are:

• A single filer
• Married filing jointly
• Married filing separately
• Head of a household

5. State Income Withholding Tax

State withholding tax also varies by tax bracket and filing status. States with the highest income taxes (above 10%) include California, New Jersey, and Hawaii. However, there are currently seven that do not assess income tax at all:

• Alaska
• Florida
• Nevada
• South Dakota
• Tennessee 
• Texas
• Wyoming

How to Minimize Taxes on Your Severance Pay 

Although it’s impossible to avoid severance package tax altogether, there are a few tactics you can employ to minimize your contributions.

1. Negotiate a Payment Plan

Staggering your severance pay relieves the burden of a one-off payment. Plus, spreading out your payments could lower your tax bracket and tax rate. 

2. Contribute to an HSA

Making contributions to a health savings account (HSA) is a great way to reduce your tax burden and simultaneously save for future medical expenses. HSAs are pre-tax accounts, and the current contribution limit stands at $3,850 for individuals and $7,750 for families.

3. Save for Retirement

You can contribute up to $7,000 a year to an individual retirement account (IRA), and your money isn’t taxed until you withdraw it when you retire. Other options include paying into a Roth IRA (which taxes you for contributions but not withdrawals) or contributing to your employer’s 401(k) plan.

4. Cover Education Costs

Putting severance payments into a 529 plan allows parents to save and pay for their children’s education. Specific regulations vary by state, but 529 earnings are not subject to federal or state income taxes. 

Severance Pay Taxes: A Summary 

Is severance pay taxable? Yes. Severance pay is considered taxable income by the IRS.

What is the severance pay tax rate? Everyone has to pay social security, Medicare, federal unemployment, and federal income taxes based on filing status and tax bracket. State income tax rates vary.

How can you minimize your contributions? Try to spread out your payments or contribute to a pre-tax account like an HSA, IRA, or 529 plan.