Is Severance Pay Taxable? How Job Loss Affects Your Taxes

Is severance pay taxable? You’d think that the IRS would cut you some slack if you’ve lost your job. Sadly, it will not. There are no tax breaks for the unemployed. You can’t deduct job search expenses from your taxable income, and even unemployment benefits are taxable. The news is not great, but you can make Uncle Sam’s bite a little less vicious if you plan ahead.

How Is Severance Pay Taxed in the US?

Is severance pay taxable if you lose your job? The short answer is yes. Severance pay is considered taxable income, according to IRS rules. The IRS also extends this classification to unemployment compensation and payments for accumulated vacation and sick time. That means you'll pay tax on any amounts you receive. 

Severance pay and the other types of compensation mentioned above are taxable in the year paid. Your employer may withhold the necessary tax amounts for you automatically when distributing severance pay, vacation pay or sick pay. These payments may arrive in installments or be made in a single lump sum. 

So how is severance pay taxed? Severance pay is subject to Medicare and Social Security tax, federal unemployment tax (FUTA), and federal and state withholding rules. Here's how the amounts for each one break down:

• Social Security tax: 12.4% (6.2% paid by the employer and 6.2% paid by the employee)

• Medicare tax: 2.9% (1.45% paid by the employer and 1.45% paid by the employee)

• Federal unemployment tax: 6%, paid by the employer on the first $7,000

It's important to note that the IRS considers severance pay to be supplemental wages for income tax withholding. Employers must apply a flat 22% tax rate for those withholdings. State withholding amounts depend on where you live, your tax filing status and your tax bracket. Keep in mind that some states do not assess income tax. 

If you're getting unemployment benefits, you'll have to opt into withholding. Otherwise, you could be in for a surprise at tax time. The IRS did offer an exclusion of taxation for up to $10,200 in unemployment compensation benefits. The exclusion was limited to the 2020 tax year only.

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What if You Have a Loan Against Your 401(k)?

Borrowing from your 401(k) is something you might consider if you need funds for home improvements or other expenses. If your employer allows 401(k) loans, you can generally borrow the lesser of $50,000 or 50% of your vested balance. You have five years to pay back the loan at an interest rate set by the plan.

There is, however, a caveat. If you leave your job for any reason, you must pay the loan balance in full. It doesn't matter whether you quit, get fired or retire.

If you cannot repay the rest of the loan, your employer must report it as a distribution on Form 1099-R. This distribution is then subject to ordinary income tax. You may also have to pay a 10% early withdrawal penalty if you're under age 59 ½. The IRS does allow some exceptions to this rule, including early distributions taken because you become permanently and totally disabled.

One way to avoid this potentially painful tax scenario is to roll the loan balance over to an IRA or another qualified retirement plan. You can request a direct rollover, which means your old plan sends the money to your IRA for you, so you don't have to worry about any unexpected tax consequences. 

State Taxes and Severance Pay

Different states tax severance pay differently. Here are some details that might affect you.

• State income tax: You might not have to pay state income taxes on your severance pay if you live in one of the nine states where there's no personal income tax. They are Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming. 

• Filing requirements: Make sure you file all the necessary state tax forms. Missing these can lead to penalties.

In most places, severance pay is taxed as income. A qualified tax professional is the best person to advise you on your potential state tax liability.

Severance Pay vs. Unemployment Benefits

You might be entitled to receive both severance pay and unemployment benefits. They aren’t the same, and they don’t come from the same source. Here are the main differences:

• Source: Severance pay is from your employer when you're laid off. Unemployment benefits come from the state if you're out of work through no fault of your own.

• Taxes: Severance pay is taxable income, and is taxed like wages. Nine states, mentioned above, don’t charge income tax. Unemployment is subject to federal income tax, but five states give you a break when it comes to state taxes. They are California, New Jersey, Oregon, Pennsylvania, and Virginia.

• Impact on benefits: Receiving severance pay might affect your eligibility for unemployment benefits. Some states reduce your benefits if you receive severance pay because severance pay is income, and unemployment benefits are based on your recent income. Unemployment, however, has no effect on severance. If your employer chooses to offer severance, that’s up to them and it doesn’t depend on your other potential sources of income.

• Duration and amount: Severance pay is typically a one-time payment based on your service. Unemployment benefits are for a set period, usually up to 26 weeks. During that time, you may have to fulfill your state’s requirements, such as by searching for a new job.

Real People, Real Savings 

Here are some examples of how people saved on taxes after receiving severance pay:

Reddit user ey49 received severance from an Arizona job at the same time he moved to New York. His employer withheld taxes for both states. Other users advised him that in the state where he lives, he could apply for a “credit for taxes paid” to the other state. States recognize the concept of double taxation, but it’s up to you to learn how it works and where taxes are actually due.

Reddit user tomt41 said that his now-deceased momn’s former employer neglected to withhold taxes from her severance pay, and his tax software wants to know what kind of income it was. He was advised that the employer was legally responsible for half of the FICA (social security) obligation and to report it as wages the employer forgot to report.

Easing the financial burden of a job loss requires research and planning. It’s important to reach out and ask questions, rely on qualified professionals for advice, and be extra careful with the money until you know what your final tax liability will be.

Tax Planning if You Lose Your Job

A job loss can have significant implications for your financial situation, including what happens at tax time. There are some potential pros and cons to consider when managing your tax liability. 

• Your income may go down. If a job loss means an extended loss of income, that could put you in a lower tax bracket for the year. You may pay less in taxes even if your income is supplemented by severance pay, vacation pay, sick time, or unemployment benefits. 

• Unemployment benefits are taxable. If you're eligible to receive unemployment compensation, this could be a valuable lifeline until you're able to get back to work. Consider, however, what the consequences of not electing voluntary withholding might be once it's time to file your yearly return. 

• Weigh side hustle benefits. A side hustle could generate more income. But you have to pay self-employment taxes on the money you earn (you deduct your business costs and pay tax on your profits). If self-employment income is significant, consider making estimated tax payments during the year to avoid penalties. 

• Think carefully about retirement plan withdrawals. If you have no other financial resources to fall back on, you may consider taking an early withdrawal from your 401(k) or an IRA. Similar to the tax rules for 401(k) loans, these amounts would be taxable as income and you could get hit with the 10% early withdrawal penalty. 

• There are no deductions for job losses. There is no deduction for losing your job. There is a silver lining since a lower income could make it easier to qualify for the Earned Income Tax Credit (EITC). Tax credits reduce your tax liability dollar for dollar. 

Also, consider what you might be able to do to offset some of your tax liability if you're receiving severance pay or other job-loss-related benefits. For example, you could take some of the money you're receiving and put it into an IRA. Contributions to a traditional IRA are tax-deductible, up to certain income limits. Deductions reduce your taxable income for the year. 

You could also save in a Health Savings Account (HSA) if you have one. An HSA is tied to a high deductible health plan and allows you to save money for future health care expenses on a tax-advantaged basis. Your money grows tax-deferred, contributions are tax-deductible and withdrawals are tax-free when used for qualified medical expenses. 

A 529 college savings plan doesn't offer tax deductions for contributions, but the money you withdraw is tax-free when used to pay for eligible education expenses. You might consider putting some of your severance pay into one of these accounts if you'd like to catch a tax break later when it's time for your child to go to college. 

Increasing charitable donations could yield another tax deduction. However, you'll have to itemize to deduct contributions, so this option might not work for you if you usually take the standard deduction. 

One final option is to attempt to negotiate the terms of your severance package so that payments are spread out over multiple tax years. The amounts you receive would still be taxable, but you wouldn't have to pay all the tax at once. 

Making the Most of Your Severance Pay: Tax Strategies

When you lose your job, you have to keep a closer watch on your money. Every dollar counts. You could keep more of your severance pay by using tax planning strategies that could reduce your tax bill:

• Spread out payments: Talk to your employer and ask if the severance pay can be paid to you in installments over two years, instead of a big lump sum. Less income this year could keep you in a lower tax bracket.

• Boost retirement savings: If you can afford to, put some of your severance pay into retirement accounts. That could lower your taxable income, with the added bonus of helping your nest egg grow.

• Pay for education. Education costs may be tax deductible. If you use your severance pay for school or training programs, you might not have to pay taxes on that money.

• Tax breaks: You’ll want to make sure you’re taking advantage of any deductions and tax credits you qualify for, like the Earned Income Tax Credit. Deductions lower your taxable income, and credits lower your tax bill. 

• Plan for withholding: Your severance pay might \be issued as a regular paycheck with all the normal withholdings. Make sure taxes are withheld, and consider increasing the amount that’s withheld, to reduce the chance of owing a big chunk of money come tax time.

If you’ve prepared your own tax returns in the past, consider hiring a professional tax preparer who might be more skilled at maximizing savings. For most people, income is less stable after job loss, so it’s important to get every financial advantage you qualify for.

What if You Can’t Pay What You Owe?

If you fill out your tax return and find that you owe taxes because you received severance pay or had an early distribution from a 401(k) loan, it's essential to understand what options you have. The IRS offers several federal debt relief programs to help you manage your outstanding tax bill, starting with Installment Agreements. 

Installment agreements are payment plans for IRS tax debt. Depending on how much you owe, you can apply for a short- or long-term payment plan. Long-term plans that are paid monthly do require a setup fee. But this could be a way to avoid more severe consequences for unpaid tax debt, such as a lien or an offset of your tax refund. 

If you can't pay anything on an installment plan, you might apply for an Offer in Compromise. This option lets you negotiate a payment for less than what's owed. The IRS considers Offers in Compromise on a case-by-case basis, so it's important to have a backup payment option if you cannot get approved. 

There are a couple of other options for paying taxes if you'd rather not deal with the IRS directly. For example, you could take out a personal loan to pay what's owed. You'd then pay back the lender with interest. A personal loan gets the IRS off your back, but it leaves you with potentially long-term debt.

A home equity loan may be another option. This kind of loan involves borrowing against your home's equity. You may be able to get a lower interest rate than you would with a personal loan and you could save further on interest by paying it back as quickly as possible. Keep in mind that you risk losing the home if you default on a home equity loan.

Finally, you might consider applying for a 0% introductory APR credit card. This way, you can pay off your IRS tax debt interest-free over time. Just remember that the 0% APR won't last forever, so you'll need to budget your payments carefully to avoid paying interest later on or, worse, defaulting on the balance. In that scenario, it could make sense to seek out debt relief options to help with overwhelming credit card bills.