When a person leaves their job, whether because they left voluntarily or because of termination or a layoff, they may attempt to make ends meet through severance payment or any other owed compensation (such as pay time off or accrued vacation time). However, many people have questions about whether severance pay is taxable. After all, taxes are a vital, if unwanted, part of all of our lives. Continue reading to learn more about severance pay, and if you have any further questions, speak with a knowledgeable Orange County employment lawyer.
What Is Severance Pay?
When most people think of severance pay, they think of large payments made to CEOs of companies when they are forced out of their jobs. However, regular employees also often receive severance pay upon termination of employment. Severance pay is usually based on how long a worker was employed. However, there is no federal requirement under the Fair Labor Standards Act (FLSA) for severance pay. Severance pay agreements are strictly between an employee and their employer. Severance pay can be distributed over time, which may offer tax benefits by potentially lowering the tax bracket and liability.
Severance Pay as Taxable Income
Severance pay is considered taxable income by the IRS and is subject to federal income tax. This means that the amount of severance pay received will be added to the employee’s total income for the year and taxed accordingly. The tax rate on severance pay will depend on the employee’s tax bracket and filing status. It’s essential to understand that severance pay is not exempt from federal income tax, and employees should be prepared to pay taxes on the amount received.
How Is Severance Pay Taxed?
Unfortunately, severance pay is taxable. In general, employees and employers both pay a 6.2% Social Security tax and a 1.45% Medicare tax on a person’s wages. These taxes are known as FICA, payroll, or employment taxes. Employers also pay a federal unemployment tax at a rate of 6% on the first $7,000 earned by each employee, which funds state unemployment insurance.
However, severance pay is typically made after you are done working for the employer. This leads some people to believe that they are not required to pay FICA taxes. However, this is not correct. The United States Supreme Court has ruled that severance payments are indeed regular wages that are subject to regular payroll taxes. Receiving severance pay as a lump sum can impact withholding tax rates and may push individuals into higher tax brackets, affecting their overall tax liability and refunds.
In addition to this, severance payments are classified as “supplemental wages,” which have their own tax policies. Employers are required to withhold 22% of the severance wages and pay the money to the IRS. In 43 states, state income taxes will also be withheld from severance payments.
Minimizing Taxes on Severance Pay
While it’s impossible to avoid paying taxes on severance pay entirely, there are ways to minimize the tax burden. One effective strategy is to contribute to a health savings account (HSA) or a retirement account, such as an IRA or 401(k). These accounts allow employees to set aside pre-tax dollars, reducing their taxable income and lowering their tax liability. Another approach is to negotiate a payment plan with the employer, spreading out the severance payments over two or more years. This can help avoid a large tax hit in one year and reduce the overall tax burden.
What Does This Mean for Employees?
Understanding that severance pay is taxable is valuable knowledge for employees who know they will receive a severance payment. In many cases, employees have the opportunity to negotiate a severance pay package. Because they know they will be taxed, an employee could work with their soon-to-be former employer for a higher severance pay package.
Are There Taxes on Unemployment Benefits?
Many employees receive unemployment benefits after they have been terminated from a job. While it may seem incredibly unfair, unemployment benefits are also taxable. California recipients of unemployment benefits must pay FICA taxes. However, unemployment benefits in this state are not subject to California state income taxes.
What About Unpaid Wages?
In most cases, terminated employees or those who quit their job are entitled to receive their final paycheck immediately upon termination or within 72 hours upon termination, depending on the circumstances. Employers who fail to give an employee their final paycheck on time can face additional monetary penalties for each day they are late. Because these wages are counted as a worker’s regular income, both federal and state taxes will be required to be taken out.
State and Local Tax Implications
In addition to federal income tax, severance pay may also be subject to state and local taxes. The tax implications will vary depending on the state and local tax laws. Some states may have a higher tax rate on severance pay, while others may exempt it from state income tax. It’s crucial to understand the specific tax laws in the state and locality where the employee resides to ensure compliance and minimize tax liability. Employees should consult with a tax professional to determine the best course of action for their specific situation.
What You Can Do Now
If you have been terminated from your job or anticipate that you will be terminated soon, you may be able to negotiate a severance pay package. It is a good idea to seek a consultation from a California labor and employment law attorney to help you in these situations. Your attorney may be able to help you negotiate a higher severance package and they will be able to advise you on the tax laws regarding your final payments.
Contact Callahan & Blaine for Guidance on Severance Pay
Understanding the tax implications of severance pay is essential, especially during a time of transition. At Callahan & Blaine, we have extensive experience handling employment matters, including severance negotiations and tax concerns. Our team can help you navigate the complexities of severance pay, ensuring that you are fully informed of your rights and options. Whether you need assistance negotiating a better severance package or understanding the tax implications, we’re here to support you.
For over 40 years, our firm has handled a wide range of employment cases with a focus on protecting our clients’ interests. We are prepared to work diligently on your behalf, providing clear guidance on how to maximize your financial security during this time. Call us at (714) 241-4444 or reach out through our contact form to explore your options.
