How is Severance Pay Taxed? A 2025 Guide

Understanding the complexities of severance pay tax rates is essential for employees transitioning between jobs, as it directly impacts their financial planning and tax obligations. Employees may prepare more effectively for tax deductions, handle their earnings, and investigate other tax-saving options by having a comprehensive grasp of how severance pay is taxed.

This guide includes a definition of severance pay, its tax implications, and responses to common questions.

What is severance pay?

Severance pay is payment granted to workers who are involuntarily terminated from their positions, such as due to layoffs or job eliminations. The Fair Labor Standards Act (FLSA) does not require severance pay; rather, it is generally established through arrangements between companies and their workers or their designated representatives.

Accordingly, an employee qualifies for severance pay if they secure a qualifying appointment, maintain a regular position, have served a minimum of 12 months continuous service, and are involuntarily dismissed from federal service for causes apart from inappropriate performance or behavior.

Companies must develop salary planning strategies to comply with labor laws, retain talent, and ensure financial stability. Integrating severance pay helps manage workforce transitions, reduce legal risks, and uphold the employer brand.

Why understanding severance pay taxation is important?

Learning about the taxes of severance pay is essential for proficient planning of finances during employment changes. The Internal Revenue Service (IRS) classifies severance pay as taxable income, liable to federal income tax withholding and, in numerous instances, taxes on Social Security and Medicare.

Understanding this tax obligation allows individuals to estimate their net income after separation, ensuring they’ve allocated enough funds for their tax responsibilities and avert unanticipated expenses.

How is severance pay taxed?

In the United States, severance pay is classified as taxable income and is liable when it’s applicable. The Internal Revenue Service (IRS) classifies severance payments as wages, mandating that they be filed in the year received and subjecting them to standard payroll tax withholding.

Federal Income Tax

Employers have to collect federal unemployment tax to severance payments. The withholding amount is based upon the total severance pay of the worker. Employers can apply the aggregate approach, which combines severance pay with regular salary for their current payroll period to ascertain the taxes withheld, or the percentage approach, which involves withholding a certain percentage as mandated by the IRS.

Social Security and Medicare Taxes (FICA)

Severance payment is liable to Social Security and Medicare taxation. Employers are required to deduct the worker's part of these taxes and remit the employer's share as well. The Social Security taxes are 6.2% for workers as well as employers, whereas the Medicare taxation rate is 1.45% for both, with no wage limit.

State Income Tax

The taxation of severance pay differs by state. Some states apply federal guidelines and tax severance in paychecks, others may have their own regulations or exemptions. While some states, such as Florida and Texas, don't collect income taxes, others, like California have systems that could potentially increase tax bills for higher rates. Accurate tax planning requires understanding of state-specific regulations.

Total compensation planning can be utilized to eliminate manual work and expedite compensation planning to better manage your employees’ severance pay and other incentives they receive from the company.

FAQs

Here are some common questions about severance pay.

Is severance taxed at a higher rate?

Severance pay is not inherently subject to a higher tax rate. Although the manner wherein taxes are withheld, and the influence of your total revenue can affect your tax liability. It is essential to recognize that the withholding rate might not correspond to your actual tax rate. The sum of the tax liability will be determined by the total income and any necessary deductions that are taken into account when you submit your annual tax return.

Does severance get taxed like a bonus?

Yes, severance pay can be taxed in a manner similar to bonuses, as the two are regarded as supplemental compensation. Employers have the option of withholding taxes using either the aggregate method, which combines severance with regular paychecks, or the percentage method, which applies a fixed withholding rate.

Is separation pay and severance pay the same?

Separation pay and severance pay are frequently used interchangeably, as both of them refer to compensation that is issued to a worker upon termination of employment. Separation, severance, termination or dismissal are all terms that may be used to describe payments that are the result of terminating the employment of a worker. Regardless of their term, they are considered taxable compensation.

Can severance pay be paid in installments?

Yes, severance payment may be distributed in installments. According to the U.S. Department of Labor, severance pay is a matter that is settled between a company and a worker. This implies that the terms which cover the payment schedule are established by mutual consent of both parties. Employers can decide to distribute severance pay in lump sums, based upon the terms that have been negotiated.

How is severance pay taxed in California?

Severance pay in California is taxable at state income tax rates, which as of 2024 range from 1% to 13.3%. A worker's total income determines the precise rate, and a significant severance package tax may put them in a higher tax bracket.

How is severance pay taxed in New York?

Severance pay is taxed as ordinary income in New York State, where it is subject to state income tax rates that are determined by total earnings. Employees in New York City may also be subject to local income taxes, which would increase their total tax liability on severance payments.