Severance pay is money an employer gives to an employee when their job ends due to layoffs, downsizing, or company restructuring.
What Is Severance Pay?
Severance pay is money an employer gives to an employee when their job ends due to layoffs, downsizing, or company restructuring. It is not a legal requirement in the U.S. but many companies offer it as part of an employment contract or company policy.
The payment can come as a lump sum or as continued salary for a set period. Severance is different from wages or a bonus because it is compensation for job loss, not for active work. However, the IRS treats severance pay as taxable income, and that creates confusion for many employees.
Is Severance Pay Taxable?
Yes, severance pay is taxable. The IRS considers severance pay to be income, just like wages. This means federal income tax, Social Security, Medicare, and state income taxes apply.
Some employees are surprised because they assume severance is a benefit or settlement, but the IRS makes no distinction. If you receive a severance package, it is subject to the same rules as other forms of compensation.
How Is Severance Pay Taxed?
Severance pay is taxed in two main ways:
- Federal income tax withholding – Employers usually withhold taxes on severance pay, just as they do on regular wages.
- Social Security and Medicare taxes – These payroll taxes also apply to severance.
- State and local taxes – If your state has income tax, severance pay is also included in taxable income.
The method of payment matters. If the severance is paid in installments, it is taxed as regular wages. If it is paid as a lump sum, the IRS often treats it as supplemental wages, which can change the withholding method.
Is Severance Pay Taxed at a Higher Rate?
Many people feel their severance pay is taxed at a higher rate, but that is usually because of how withholding works.
Employers may use the percentage method (a flat 22% federal withholding for supplemental wages under $1 million) or the aggregate method (adding severance to your last paycheck and withholding based on your tax bracket).
It does not mean the IRS has a separate higher tax rate for severance pay. The actual tax you owe depends on your total annual income and your tax bracket.
Severance Pay vs. Earned Income
Employees often ask if severance pay is considered earned income. The IRS does classify severance as income, but it is not "earned" through active work. It still counts as taxable wages and is reported on your W-2 form.
Because it is treated as wages, severance pay can affect:
- Unemployment benefits – Some states reduce benefits if severance is received.
- Retirement contributions – Severance is not always eligible for 401(k) deferrals.
- Tax credits and deductions – A higher income in the year of severance could reduce eligibility for certain credits.
How Much Tax Is Taken Out of Severance Pay?
The exact amount depends on federal, state, and local tax rules.
- Federal withholding – 22% flat if treated as supplemental wages. If the severance pushes income into a higher tax bracket, more may be due at tax filing.
- State taxes – States like New York tax severance as regular income. Some states with no income tax, like Florida or Texas, only withhold federal tax.
- Example – An employee receives $20,000 in severance in New York. At 22% federal withholding plus state and payroll taxes, about $6,000–$7,000 may be withheld immediately.
Can You Reduce or Avoid Taxes on Severance Pay?
You cannot avoid taxes completely, but planning can help reduce the impact. Strategies include:
- Deferring payment – Requesting the employer to spread severance across tax years to avoid a single large lump sum.
- Retirement contributions – Using severance pay to contribute to an IRA if eligible.
- Tax withholding adjustments – Reviewing your W-4 to ensure accurate withholding.
Working with a tax professional is important. For example, our CPA Services in New York can help you plan severance tax strategies, avoid underpayment penalties, and prepare for year-end filing.
Severance Pay and State Taxes
Severance pay is taxed differently by state.
- New York – Severance is fully taxable as regular income and subject to state and city taxes.
- California – Also fully taxable, with state income tax applied.
- States without income tax – Only federal and payroll taxes apply.
Employees in New York, especially, should plan ahead because combined state and city taxes can significantly increase the effective tax rate. Consulting business consultants in NYC or small consulting firms in NYC can provide guidance for handling these obligations.
When to Consult a Professional
Severance pay can create unexpected tax bills. Consulting a tax professional is recommended if:
- You received a large lump sum severance package
- You are close to a higher tax bracket
- You want to reduce the effect on unemployment or retirement benefits
Our firm, GTA Accounting Group, provides professional support through:
- CPA Services New York – For tax filing, planning, and severance calculations
- Business Consultants NYC – For strategic financial planning after job loss
- Small Consulting Firms NYC – For guidance on restructuring personal finances
- Bookkeeping Services NYC – For tracking severance, expenses, and year-end taxes
Final Thoughts on Severance Pay Tax
Severance pay is taxable income. Federal, state, and payroll taxes apply, and the method of payment affects withholding. While many employees feel severance is taxed at a higher rate, the truth is that it follows the same tax bracket rules as wages.
Proper planning can reduce the impact. Using retirement contributions, spreading payments, and consulting professionals are effective strategies. GTA Accounting Group can assist with CPA Services in New York, bookkeeping, and consulting to help you manage severance pay taxes and stay compliant.
