How is my severance package taxed?
I was laid off due to Covid 19. If I get a lump-sum severance of $15,000, what percent of taxes will be taken out?
Joshua Escalante Troesh, CFP | MBA
Severance packages are considered compensation by the IRS and are taxed the same as other income from a job, but this means not all of your severance is subject to taxation. Reviewing the terms with your CPA or financial advisor can help you know exactly how it is taxed. If you are still negotiating your severance, you have an opportunity to lower your taxes by changing the terms of the package.
The Severance Agreement Controls
The taxation of a lump sum severance depends on the specific nature of the severance and what the money is for. You would need to look at your severance agreement to determine what specifically the severance moneys are for to determine the true tax implications.
The agreement should contain a breakdown of what the $15,000 represents; including ordinary compensation, health insurance premiums, and other benefits. You can use these numbers to estimate the withholdings you will see on your severance package (and the taxes you will owe at the end of the year).
Taxation of Ordinary Compensation
Generally, severance money is included as ordinary income and you will see a similar withholding for Federal and State taxes as you would for a normal paycheck. You can use your previous paycheck to determine your personal withholdings percentage by dividing the total withholdings by the gross pay from the paycheck statement.
The withholding on your severance may be a greater percentage due to the way withholdings are calculated by your company. If this is the case, you would effectively have overpaid your taxes and would get a refund in April of next year.
Healthcare Premium Moneys May Avoid Taxation
For the portion of a severance designated to pay for continuation of healthcare, this may qualify for avoidance of income taxes and would not be subject to income tax withholdings. In order for this to happen, the moneys must be used (nealy) immediately to pay for healthcare premiums.
Avoiding taxes is especially easy if your company will directly pay the premiums for you or sends you the money monthly. If not, discuss the avoidance with your CPA or financial advisor. Again, you would need to look at the agreement to determine what portion, if any, of the severance moneys are for the payment of healthcare premiums.
Other Fringe Benefits
Other benefits may also qualify for this special tax treatment and avoid withholdings. The IRS tax code has a special meaning for the term “fringe benefits” and offers a short list of benefits that qualify. Fringe benefits avoid taxation, and any money in the severance designed to continue those specific benefits may also avoid taxation. Your former- employer’s Human Resources Department may be able to provide you with a more specific breakdown of what qualifies as a fringe benefit from your employer.
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