Is Severance Pay Taxed Differently Than Regular Pay? Unveiling the Details

When you receive a severance package, understanding how it is treated in terms of taxes is crucial. Adam Maass has explained the intricacies of tax withholding, but there is more to it than just the initial withholding. This article aims to clarify the tax implications of severance pay in the United States, focusing on how it is differentiated from regular income.

IRS Guidelines on Severance Pay and Taxation

The Internal Revenue Service (IRS) has specific guidelines regarding the taxation of severance pay. There are two primary methods that can be used to pay severance:

Combining Severance Amount with Last Regular Paycheck: In this scenario, the severance pay is added to your final regular paycheck. The tax withholding in this case can be substantial, and the specific tax amount depends on the total amount. Essentially, the tax that a worker is required to pay in this instance will likely be higher than for a regular paycheck because the total income for the pay period is now increased. Since severance pay is typically considered additional income, it can trigger a higher withholding rate due to its potential for being a significant sum.

Supplemental Tax Rate: For severance payments that are considered "supplemental" income, they are taxed at a separate rate. This supplementary tax rate can have significant implications for how much tax you end up paying. Prior to the Tax Cuts and Jobs Act of 2017, the supplemental rate was 25%. However, as of 2023, the supplemental rate has been reduced to 22%. This change was implemented because workers who receive severance payments might start a new job immediately and would otherwise have insufficient taxes withheld throughout the year. This lower rate ensures that the tax burden on these workers is more manageable.

Understanding Tax Withholding and Your Tax Liability

When dealing with severance pay, it is essential to differentiate between the withholding rate at the time of payment and the eventual tax liability at the end of the tax year. In the United States, there are two significant tax considerations:

Tax Withholding: This is the amount of tax that is automatically deducted from your paycheck before it is issued to you. The withheld tax becomes a credit on your tax return and can reduce your overall tax liability. When it comes to severance pay, the withholding rate may be higher due to the nature of the payment and the fact that it is considered additional income. This can result in a larger tax withholding than typical paychecks, especially for significant severance packages. Eventual Tax Liability: When you file your tax return at the end of the year, all your income, including any severance pay received, is summed up. Any deductions are then subtracted, and the remaining amount is taxed at the appropriate graduated rates. For most individuals, this means that severance pay is treated just like any other income – it gets included in your total income and taxed accordingly.

Welcome to a New Job, No Change in Withholding Rules?

One interesting point highlighted by Adam's explanation is that even if you start a new job immediately after receiving severance pay, the tax withholding rules for severance remain the same. This means that the supplemental tax rate applied to your severance still stands, regardless of whether you start a new job. This can be a bit murky for employees as they step through the transition. To navigate this effectively, it is important to understand the two main ways severance pay is taxed:

Withholding on the Final Paycheck: If your severance is included in the last paycheck, the tax withholding will be determined by the total income for that paycheck, which can be higher than the withholding from a regular paycheck.

Supplemental Tax Rate: For severance paid at a rate deemed higher than regular pay, the 22% supplemental tax rate applies. This rule ensures that workers who transition jobs have the necessary taxes withheld, preventing issues with tax compliance.

In conclusion, while severance pay can add complexity to your tax situation, it is important to understand that the IRS treats the severance amount similarly to other sources of income in terms of tax liability. By being aware of the different methods of withholding and the supplemental tax rate, you can better prepare for the tax implications of your severance payment. If you have further questions or need specific guidance, consulting with a tax professional would be a prudent step.