Severance pay may be given to individuals by their company when their employment is terminated. It's taxed as ordinary income and the employer will withhold taxes on it and include it in the employee's Form W-2 for the year, but there are ways to reduce the tax burden.
You might consider paying some of it into a tax-advantaged retirement or health savings account. Maybe put some of the money into a 529 educational savings account if you're a parent or ask your employer to pay the severance out over two years to avoid tax bracket creep. You can also donate some of it to charity and take the deduction.
Key Takeaways
- You can reduce your tax bill on a severance package by directing it to an IRA.
- Consider putting some of your severance into an HSA if you have a high-deductible health insurance plan.
- Ask your employer if the company can pay you out over two years.
- You can use some of the money to fund a 529 plan.
- Consider supporting your favorite charity by using your severance pay for a donor-advised fund.
Contribute to a Retirement Account
One easy way to pay less tax on severance payis to contribute some or all of the money to a tax-deferred account such as an individual retirement account (IRA). The contribution limit is $7,000 in 2024, up from $6,500 in 2023. You can put in an additional $1,000 if you're over age 50. This is referred to as a "catch-up contribution."
Financial experts say that you should try to sock away as much as you can. According to Get Shameless' Pamela Capalad, a certified financial planner (CFP), you should try to contribute the maximum amount if you can take advantage of that opportunity.
Some employers may even allow you to put your severance pay into your 401(k). The limit for this type of plan is $23,000 in 2024 (the 2023 limit was $22,500). You can save an additional $7,500 each year if you're 50 or older.
Put It Toward Health Expenses
Putting your severance money in a health savings account (HSA)is a great way to plan for future expenses if you don’t want to put the money toward retirement.However, this approach only works if you have a high-deductible health insurance plan (HDHP).
2024 Limits
You can save as much as $4,150 for self-coverage or a maximum of $8,300 for a family plan.
The following conditions apply:
- Your deductible must be $1,600 for self-coverage or $3,200 for family coverage.
- Your out-of-pocket expenses are limited to $8,050 (self-only) or $16,100 (for family coverage).
Time Your Payout
An easy way to pay less tax is to have your severance paid out in two separate years. Ask if you can have the payments spread out to avoid taking a huge tax hit in one year. For some people, taking a lump sum can mean owing unexpected money on their taxes.
"Receiving a single, large lump-sum payment could push you into a higher tax bracket," says Tyler Landes, CFP, accredited investment fiduciary (AIF) and founder of Tandem Financial Guidance. "That could mean big changes to how much you owe."
Make sure you get advice from a financial professional so you get the best possible tax benefits for your personal situation.
Open a 529 Plan
Consider using your severance pay to invest in a 529 plan if you have kids or want to support a young niece or nephew’s college education. You may even get some state deductions for contributing.
Read through the rules carefully to make sure of the limits so your contribution doesn’t count as a gift. The IRS only lets you give away up to $18,000 in gifts per person per year as of 2024, up from $17,000 in 2023. Anything over these limits will incur a gift tax. You don’t want to cause more of a headache for yourself while you’re trying to lessen your tax burden.
You can also use a 529 to pay off up to $10,000 of your own student loan debt under the terms of the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019. It may make sense to open a 529 account, get any state tax credits available, and then immediately repay student loans.
Invest in a Donor-Advised Fund
A donor-advised fund is a unique way to offset the taxes you'd pay on your severance while supporting your favorite organization. The best part of a donor-advised fund is that it allows an individual to get the tax benefit while having a say in how an organization receives the money.
These accounts are sponsored by national charitable organizations and hold your contributions and let them grow for future distributions or grants, according to Landes.
Is Severance Taxed at a Higher Rate?
Federal unemployment tax, Social Security, and Medicare are all taxed at the same levels for severance pay. That said, the federal income tax rate may be higher depending on the amount of the payment and whether it pushes you into a higher tax bracket. And if a severance payment is made in a lump sum, it might be taxed at a higher rate because it would be larger than the normal amount you receive per paycheck.
Is Severance Taxed Differently Than Income?
Severance is not taxed differently than income. It's taxed at the ordinary income tax brackets, but it may fall into a higher tax bracket if the severance pay is made as a lump sum.
How Can I Avoid Paying Taxes on Severance?
There's no way to completely avoid paying taxes on severance pay but there are ways to reduce the amount of severance that will be taxed. This includes putting some of the severance into tax-advantaged accounts, such as HSAs and 401(k)s.
The Bottom Line
Talk to a professional if you find out that you’re receiving a severance packageand you are unsure what you want to do with the money. A certified public accountant (CPA), CFP, or other financial professional can give you smart ideas even if you think you know what’s best.
“Buyouts are a real gift, so plan accordingly,” says Peter J. Creedon, chief executive officer of Crystal Brook Advisors. “You need to see and understand the whole picture before making a large financial decision.”
