“How to Manage Taxes on Your Severance Pay”

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How Severance Pay Is Taxed

Losing your job can be a significant financial setback, but severance pay can help ease the transition. When you lose your job involuntarily, your employer may offer severance pay as a goodwill gesture. However, it’s important to understand that severance pay is taxable as regular income, and taxes are withheld from your severance check. This income will be included on your annual W-2, making it easier to report during tax season.

How Severance Pay Is Taxed

Severance pay is taxed similarly to your regular wages. You’ll pay federal income taxes, Social Security, Medicare, and federal unemployment tax. Taxes are generally withheld from your severance check in one of a few ways:

• As regular wages: If your employer treats your severance check as regular wages, they’ll withhold federal and state income taxes, Social Security, Medicare, and so on before you receive the money. If you receive a lump sum, your withholding might be calculated using a higher tax bracket.
• As supplemental wages at a flat 22%: If treated as supplemental income, your employer may withhold a flat 22% for federal taxes.
• At 37% on supplemental wages exceeding $1 million: For example, if you receive $1.2 million in severance pay, $200,000 will be subject to a flat 37% withholding.

Your severance pay and any taxes withheld will be reported on your W-2, along with your regular wages and withholding. Withholding doesn’t determine how much you’ll owe at tax time; you’ll reconcile wages and withholding on your tax return to calculate your tax liability.

How to Mitigate the Tax Impact of Severance Pay

Depending on when you start a new job, severance pay could increase your income—and your tax bill—for the year. For instance, starting a new job immediately after leaving your old one means the severance pay is “extra” taxable income. This could even push you into a higher tax bracket.

To minimize taxable income, consider contributing to a tax-advantaged account:

• Contribute to your 401(k) or other employer-sponsored plan
• Contribute to a traditional IRA, as your contribution is tax-deductible in the year you contribute
• Contribute to a health savings account (HSA) if you have a qualifying high-deductible health plan

If you itemize your deductions, you can deduct qualifying charity donations of up to 50% of your adjusted gross income. You might also consider asking your employer to split your severance payments between two years to spread out the tax impact.

What if Losing Your Job Means a Significant Loss of Income?

Even with severance pay, your income may be down for the year if you are out of work for an extended time. In such cases, using your severance pay to cover expenses makes more sense than contributing to a retirement fund or HSA.

If you replaced your employer’s health plan with insurance from a marketplace, you may be eligible for the advance premium tax credit. You may also qualify for the earned income tax credit if your income is lower due to unemployment.

Tips for Preparing for Tax Season

Because losing or changing your job and receiving severance pay can complicate your taxes, consider working with a professional tax advisor. A tax pro can help ensure that you’ve accounted for all of your income and withholding, maximized your credits and deductions, and may help you gauge whether you’ll need to pay additional taxes or make a quarterly estimated payment.

Here are a few things to think about as tax time approaches:

• Mind Contribution Deadlines: Contributions to an employer-sponsored plan like a 401(k) must be made in the year you take the deduction. For 2023, the deadline to contribute is December 31, 2023. IRA and HSA contributions must be made by the tax-filing deadline in the following year.
• Double-Check Income and Withholding: Your W-2 should reflect your wages and severance pay, as well as funds withheld for federal and state income taxes, Social Security, Medicare, federal unemployment tax, and retirement contributions. Double-check for accuracy and let your employer know if you find a discrepancy.
• Account for Additional Income: Severance pay aside, you may have additional unemployment-related income to account for on your taxes, including unemployment benefits, vacation and sick pay you redeemed when you left your job, and pension withdrawals.
• File by the Usual Deadline: Tax season typically kicks off in early February. You can’t file sooner than the IRS start date, even if you expect a refund and would like to get it early.

The Bottom Line

Paying taxes on severance pay adds an item or two to your mental to-do list, and no one likes paying additional taxes. However, paying taxes on severance is better than not getting severance at all. The additional funds can help smooth the transition to your next career move and help manage expenses, including timely payments on your credit cards and loans to keep your credit reports in good shape.

For any mortgage service needs, call O1ne Mortgage at 213-732-3074. We are here to help you navigate your financial journey with ease and expertise.

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