How to Minimize or Avoid Paying Taxes on Severance Pay

Receiving a severance package after leaving a job can provide crucial financial support during your transition period. However, that relief might be dampened when you realize how much of your severance pay could be claimed by taxes. Severance payments are typically subject to income tax. However, there are legitimate strategies to minimize or eliminate taxes on severance pay. This helps you keep more of your earnings. Your departure may have been voluntary or part of a company restructuring. Either way, understanding the tax implications of your severance package can help you maximize its value. From strategic timing of your payment to utilizing retirement account contributions and exploring potential deductions, this is ​​how to avoid tax on severance pay.

A financial advisor can help protect you against crucial tax burdens you may not need to pay.

How Severance Pay Works

Severance pay is compensation provided by employers to employees who are terminated due to circumstances beyond their control. These payments typically come as part of a severance package. This can happen when an employee is laid off, a position is eliminated or a company undergoes restructuring. The amount often correlates with factors like length of employment, position level and company policy.

Comprehensive severance packages often extend beyond just monetary compensation. They may include continued COBRA health insurance coverage or outplacement services to help with job searching. It can also include payment for unused vacation or sick time. Some employers might also offer to maintain certain benefits, like life insurance, for a limited period.

Most employers calculate severance pay based on a formula that considers years of service. A common approach is to offer one or two weeks of regular salary for each year worked at the company. For executives or senior-level employees, this formula might be more generous, sometimes offering a month’s salary per year of service. ¹

How severance pay works can vary significantly between companies. Some employers distribute the payment as a lump sum, providing the entire amount at once. Others may choose to continue regular salary payments for a designated period. It essentially keeps the employee on payroll without the work responsibilities. Each method carries different tax implications and timing considerations.

How Severance Pay Is Taxed

Severance pay is considered taxable income by the IRS. This means it is subject to federal income tax withholding just like your regular wages. ² When you receive a severance package, your employer typically withholds taxes at a flat 22% supplemental wage rate. However, higher earners may see a 37% withholding on amounts exceeding $1 million. This withholding includes not just federal income tax but also Social Security and Medicare taxes (FICA). ³

How your severance pay is taxed can vary, depending on whether you receive a lump sum or installments. A lump sum payment might push you into a higher tax bracket for that year. This results in a larger tax burden. However, payments spread across multiple tax years could help keep you in a lower tax bracket each year. This reduces your overall tax liability.

Beyond federal taxation, your severance pay is also subject to state and local income taxes in most locations. The rates vary significantly depending on where you live. Some states have no income tax at all, while others may charge rates approaching 13% or more. It is important to account for these additional tax obligations when planning how to manage your severance package.

Certain components of your severance package may be taxed differently. For example, payment for unused vacation or sick time is taxed as regular income. However, if your severance includes continued health insurance coverage, this benefit typically is not taxable.

Additionally, the rules change if your severance agreement includes compensation for damages like emotional distress or discrimination. These amounts may have different tax implications, depending on the specific circumstances.

Ways to Reduce Taxes on Severance Pay

After leaving a job, severance pay can provide financial stability during your transition. However, it often comes with a significant tax burden. Understanding how to avoid taxes on severance pay can help you retain more of your hard-earned money during an already challenging time.

• Contribute to retirement accounts: If you are still eligible to make elective deferrals from compensation through your employer’s plan, contributing to a qualified retirement accounts like a traditional 401(k) may reduce your current taxable income. Whether severance itself can be deferred into the plan depends on the plan and applicable compensation rules. For 2026, the employee elective deferral limit for a 401(k) is $24,500, with an $8,000 catch-up contribution generally available to participants age 50 and older. A traditional IRA contribution may also be deductible, but eligibility for the deduction depends on factors including income, tax filing status, and eligibility to contribute to a workplace retirement plan.
• Request payment distribution across tax years: If possible, negotiate so you receive your severance across multiple tax years. This is instead of one lump sum, which could bump you into a higher tax bracket the year you receive it. Spreading payments may reduce taxes if it keeps some income out of higher marginal brackets, but the result depends on your income and tax situation in each year.
• Offset with deductible expenses: Consider timing deductible expenses to coincide with the year you receive severance pay. This might include expenses such as medical expenses or charitable contributions. These deductions can help offset the additional income and reduce your overall tax liability.
• Explore health savings accounts: If eligible, direct some severance pay into a Health Savings Account (HSA). This provides a triple tax advantage: tax-deductible contributions, tax-free growth and tax-free HSA withdrawals for qualified medical expenses.
• Negotiate for non-taxable benefits: Some employer-provided benefits may receive different tax treatment from cash severance, but they are not automatically tax-free. For example, the tax treatment of outplacement services can depend on how and why the employer provides them. If an employee accepts outplacement services in exchange for reduced taxable severance, the reduction can still be treated as wages for employment tax purposes.

Why Severance Withholding and Your Tax Return Can Differ

Your employer may take federal income tax out of your severance before the money reaches you, and that amount is treated as withholding toward your federal taxes for the year rather than a final calculation of what you owe.

In some situations, severance paid separately from regular wages can have federal income tax withheld at a flat 22% rate. That percentage is used for payroll purposes, while your final federal tax amount is figured later using your total taxable income and the details on your tax return.

For example, suppose you receive $100,000 in severance and your employer uses the 22% method. Federal income tax withholding would be $22,000, leaving $78,000 before other deductions. Social Security and Medicare taxes may also apply, along with state or local taxes where required.

Now suppose that after all of your income is included on your tax return, the severance ends up increasing your federal income tax by $26,000. The $22,000 already withheld would cover most of that amount, leaving a $4,000 difference. Whether you actually have $4,000 left to pay depends on the rest of your return, including taxes withheld from other pay and any credits or payments you qualify for.

If the total amount paid toward your federal income tax during the year exceeds your final federal income tax liability, the excess may increase your refund or reduce another balance due. Your tax return determines the amount you ultimately owe or receive based on your income, payments and credits for the full year.

Reviewing your wages, severance, unemployment benefits and other taxable income can help you see whether enough federal income tax has been paid during the year. If you are on track to owe more, you may be able to increase withholding from other income or make an estimated tax payment, depending on your tax situation and the applicable payment deadlines.

How Severance Pay Affects Unemployment Benefits

Whether your severance delays or reduces your unemployment benefits depends on where you live. Each state sets its own rules on how severance affects eligibility, and the differences are significant. Some states treat severance as disqualifying income for the number of weeks the payment covers, effectively postponing the start of your benefits. Others ignore severance entirely and allow you to file for unemployment immediately after your last day of work.

The structure of your severance settlement also matters. Your state may treat a lump sum paid on your last day differently than continued salary payments that keep you technically on payroll for several months. In states that tie unemployment eligibility to whether you’re still receiving wages, staying on payroll through extended severance payments can push your benefits start date back by the full length of those payments. This distinction rarely comes up during severance negotiations, but it can have a meaningful effect on your cash flow budgeting.

If your employer offers you a choice between a lump sum and installment payments, check your state’s unemployment guidelines before you decide. Your state labor department’s website will typically spell out how severance is classified and whether it affects benefit eligibility, benefit amounts or both. Your employer’s HR department may not provide it, and many laid-off workers don’t learn about it until they file their claim and receive an unexpected denial or delay.

For people with significant severance packages, the unemployment benefit itself may seem small by comparison. But unemployment insurance also serves as a gateway to other benefits in some states, including subsidized health coverage and job training programs. Delaying your eligibility for unemployment can delay access to those programs as well.

Bottom Line

Severance can raise your tax bill in the year you receive it, but the way it’s paid leaves some room to plan. Directing part of it into your workplace retirement plan if the plan allows, asking your employer to spread payments across two tax years or putting money into a health savings account if you’re eligible may lower the amount that’s taxed. Running the numbers before you sign the agreement keeps the most options open.

“Tax planning becomes even more important when you receive large severance packages because the tax withholding may be inadequate when you factor in other income. It’s imperative that you look at a tax projection to make sure you won’t face an underpayment penalty,” said Matthew Hofacre, MSPFP, CFP®, EA.

Matthew Hofacre, MSPFP, CFP®, EA provided the quote used in this article. Please note that Matthew is not a participant in SmartAsset AMP, is not an employee of SmartAsset and has been compensated. The opinion voiced in the quote is for general information only and is not intended to provide specific advice or recommendations.

Tips for Tax Planning

• A financial advisor with tax experience can help you understand how to protect your assets and prepare in advance for future tax liability. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• If you’re curious what you might owe in taxes next year, consider estimating it with an income tax calculator.

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