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Adding Insult to Injury: Tax on Severance Pay

written by: Nicole Luck•edited by: Elizabeth Wistrom•updated: 7/14/2010

Educate yourself on the possible tax implications related to job loss to ensure compliance with tax regulations. Just what is the tax on severance pay?

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    After losing their jobs, recently unemployed workers may find additional disappointment when confronted with having to pay taxes on severance pay. In the current state of the economy, businesses are searching for ways to reduce overhead costs. Unfortunately, with a continued reduction in costs, employees find themselves on the proverbial chopping block. While little will provide solace to those who find themselves out of work, severance pay can provide the means for survival while applying for unemployment and looking for new employment. Once the emotional impact of job loss has worn off, it’s important to face reality head on and seek help when necessary with vital financial matters. "What is the tax on severance pay?", you may ask yourself. Though losing your job can be traumatic, arming yourself with the tools to cope effectively and understanding the tax consequences related to loss of employment can offer some peace and assurance going forward.

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    Tax Issues

    Severance pay is required to be reported as wages by the Internal Revenue Service and each state’s department of taxation. Your former employer will report the amount received as severance pay on your W-2 and it will be taxed accordingly. Severance pay is taxed at the same rate as your income from salary and wages, which is decided by the tax rate set by the Internal Revenue Service for your tax bracket. The same holds true for state taxation rates.

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    Severance Pay

    Your employer may decide to provide severance pay in one of two ways. They may decide to pay severance in a lump sum or continue to pay salary as usual until the severance payout is exhausted. If your employer provides you with a lump sum payment, it’s important to understand that you will have to pay taxes on that amount. The Internal Revenue Service and state taxation departments provide tax rate tables which can help you calculate your tax liability based on the amount of your severance package. It may be in your interest to consult an accountant or financial advisor to ensure you set enough aside to take care of your tax liability when tax time rolls around.

    Workers receiving severance pay through a normal payout of salary over time will require less guidance related to setting funds aside to cover taxes. Your former employer will continue to allocate the appropriate amount of wages toward taxes as directed by you on your original W-4 withholding request. This will help you reduce your state and federal tax liability as usual.

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    Additional Considerations

    When confronted with an impending layoff, communication between you and your soon to be former employer needs to be proactive and direct. Request information concerning your payout and method of payment, including the time-frame and expected total payment, before separation is final. Ask your employer exactly what is the tax on severance pay and ask for guidance from human resources if available. In addition, discuss the transfer of any retirement monies due to you and receive appropriate contact information for financial representatives responsible for handling the transition.

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    Internal Revenue Service: Publication 4128: Tax Impact of Job Loss

    New York Life: What Do I Need to Know About Severance Packages?