When an employee is let go involuntarily, such as in the case of a layoff, many firms provide financial compensation, known as severance pay. In most cases, the amount is determined by the total time you were employed by the company closing its doors. Although employers are not required to provide severance pay to workers whose employment has ended, most businesses do so. At the time of the employee's departure, the employer and the employee will discuss severance pay.

Is Taxable Income Subject to Severance Pay?

Along with unemployment benefits and payments for accrued vacation and sick leave, severance pay is taxable in the year it is received, just like any other remuneration you would receive. The procedure of paying taxes is often made easier by employers that include the amount on their employees' Forms W-2 and who withhold the proper amounts of federal and state taxes. In most cases, these taxes are deducted from severance payments:

• 12.4% of income is subject to Social Security tax; employees and employers each contribute 6.2%.
• 2.9% tax on Medicare, of which 1.45% belongs to the employer and 1.45% to the employee.
• Withholding of taxes on the federal income
• Tax deducted from residents' wages by the state
• For the first $7,000 in wages, the employer is responsible for paying 6% of the federal unemployment tax (FUTA).

How to Reduce the Amount of Taxes That You Owe on Your Severance Pay

Put the Money in Your HSA

Investing in a health savings account, often known as an HSA, is an excellent method to reduce the amount of money you have to pay in taxes while also putting money aside for any future health and medical costs. HSAs, or health savings accounts, are funded before taxes and may be used to pay for qualified healthcare expenses. The maximum amount that may be contributed to an HSA by an individual in 2022 is $3,650, while the maximum amount that a family can contribute is $7,300.

Save for Retirement

You should also consider contributing to an individual retirement account (IRA). Starting in 2022, you can put up to $6,000 per year into an IRA or up to $7,000 if you are at least 50. The money you put into an IRA will not be subject to taxation until you withdraw it during retirement. You also can contribute funds to a Roth IRA, which requires you to pay taxes at the time of deposit but exempts those assets from taxation when they are withdrawn. In either scenario, IRAs may help you pay less tax to the federal government.

You Should Space Out Your Payments

Think about approaching your company with the idea of arranging a staggered severance package. It is possible to lessen the burden of paying a single big tax bill by dividing a severance package up and distributing the payments over two or more years.

Help Pay for Education

Some individuals who receive severance pay decide to invest the money in a 529 plan. These plans are vehicles for tax-favored savings that parents often use to save money for their children's future educational expenses. Rules for these programs might vary from state to state, but under no circumstances are participants required to pay federal or state income taxes on their gains. The money may be used to pay any educational expenses from kindergarten through higher education.

What Is the Amount of Severance Pay?

When calculating severance pay, it is common practice to include both the employee's base income and the total amount of time the organization employs. If a firm offers two weeks of pay for every year of employment, and you work for that company for five years, you may get ten weeks' worth of earnings at the end of your job.

As part of severance pay, an employer will often continue providing health insurance coverage for an employee for a certain amount of time. The final value of the severance pay is determined by mutual agreement between the employee and the company. Former workers have the right to maintain their health insurance coverage via their employer's plan for a certain time after leaving the company, but they must pay the premiums themselves.

Who Is Entitled to Get Severance Pay?

Employees are given severance pay by their employers if the terminating employer chooses to provide such payment as part of a severance package. In the event of a layoff, employees are often eligible for severance pay from their employers. It is not common practice for employers to pay severance payments to former workers who were fired "for cause" or conduct-related grounds.

When employers do decide to provide severance pay to dismissed employees, it is common practice for them to demand that the employee sign a separation agreement in return for the payment. These agreements often prohibit the former worker from making derogatory statements about the firm, disclosing secret information, or taking a position with a company in direct competition with the former employer.