Severance and taxes: What you need to know if you receive a package

Economic downturns often come with the announcements of staff being laid off. Right now, it feels like this is happening in droves, especially in the tech space. The silver lining for some is employers offering severance packages.

If this is sounds like your situation, you’re probably feeling overwhelmed about — well, everything— and taxes may be the last thing on your mind. But understanding the tax implications of receiving severance now, can help you navigate your near-term finances and get ahead of the next tax season.

Rest assured, H&R Block is here to help. We’ll answer common questions about receiving severance and maybe a few you haven’t thought of.  When it comes time to filing your taxes, you can rely on H&R Block to help you every step of the way.

Is severance pay taxable?

Yes, severance pay is taxable in the year that you receive it. So, if you’re receiving three-months’ worth of pay, you’ll need to factor in taxes to that amount.

Like a normal paycheck, your employer will withhold some taxes up front. How much will depend on the way they pay it out.

Employers generally use two different ways to pay your severance:

• As part of your normal wages. That means all the normal withholding (such as federal income tax based on your completed W-4, state income tax, Social Security and Medicare taxes) that applied to your paycheck, will also apply to your severance payment. 
• Apart from your normal wages. In this case, a flat 22% withholding rate for federal income tax (in place of the normal federal income tax withholding that would be calculated based on your W-4) would generally apply.

If you accumulated vacation or sick pay, your employer may pay that out at their discretion or under the terms of your employment contract when your job is terminated. Generally, the same tax withholding scenarios as above apply.

Take note: Just because taxes are withheld from your severance pay, it doesn’t mean all your taxes are covered. You’ll work that math out when you file your return. Depending on your situation, you may still owe taxes, or you may get a refund. To prevent tax time surprises, we recommend you check with your tax pro to see if you need adjust other withholding sources or make an estimated payment.

Can you collect unemployment if you get severance pay?

The answer here will depend on the state you live in, the length and amount of your severance, and other factors. Although the Department of Labor administers the guidelines, each state has its own requirements to qualify for unemployment benefits. In some states, you may only be able to collect unemployment after your severance period has expired.

Contact your State Unemployment Insurance agency to look at the other requirements and also to file a claim. Learn more about how to claim unemployment benefits.

Take note: Unemployment benefits are considered taxable income. If you do file for unemployment, be sure to request tax withholding, which will put some of this income toward your tax obligations.

How else could severance affect your taxes?

The additional income hitting you all at once could bump you into a higher tax bracket in the year you receive it.

For example, let’s say you receive six months of severance at the end of November. Effectively, you’d receive 17 months’ worth of pay during the year, which is a sizeable bump to your income compared to the past tax year.

There are two things to be aware of:

• A change to your marginal tax rate. There’s a bit to unpack here, but essentially America’s progressive tax rate bracket system means your tax rate increases the more income you have. So, if a severance package bumps you from the 22% to 24% bracket, it doesn’t mean all your income is taxed at 24% — just the last “block” is taxed at that rate.  Find out more about how tax brackets work and 2022 tax brackets.
• With more income, you may also be phased out of or ineligible for certain income-based credits or deductions.

Worried about additional tax impacts from a severance payout? There are ways that you may be able to lower your taxable income. Check with your benefit or plan administrator about how to make additional contributions to your HSA or to your personal IRA if you’re eligible.  

What other tax impacts are there after experiencing job loss?

Unfortunately, losing your job typically means you lose your insurance. However, job termination is considered a qualifying event, which means you’re eligible for a special enrollment period for marketplace insurance. In turn, you may qualify for the advance premium tax credit to help pay premiums.

Another insurance related impact is your health Flexible Spending Account (FSA). If you have an FSA through your employer, you typically forfeit those funds when your lose your job unless you continue coverage using COBRA.

Get help navigating your taxes

Severance and unemployment income can be a critical lifeline during financial setbacks. Understanding what it means for your taxes can be complex — but you don’t have to go it alone.

Whether you make an appointment with one of our knowledgeable tax pros or choose one of our online tax filing products, you can count on H&R Block to help you navigate your taxes and help you get back the most money possible.