Understanding Taxes on Severance Pay in the United States

Tax laws can be complex, and severance pay can often create additional questions for employees and employers alike. In the United States, severance pay is considered a form of supplemental income. Here, we explain the tax implications of severance pay, including the withholding rate, how federal and state taxes are applied, and additional considerations.

What is Severance Pay?

Severance pay is an arrangement made by an employer to compensate an employee who is being let go from their job. This payment can be guaranteed through an employment contract, or it may be offered on a discretionary basis. Regardless of the circumstances, understanding how severance pay is taxed is crucial for both parties.

Taxation of Severance Pay

When it comes to taxes on severance pay, it is important to understand that it is treated as supplemental wages. Supplemental pay is any income in addition to regular wages or salary. In the case of severance pay, this can include additional compensation given to an employee upon termination of employment.

Withholding Rate

The withholding rate for supplemental wages, which includes severance pay, is currently 22 percent. This rate is used to estimate the amount of federal income tax that should be withheld from severance payments. Employers use this withholding rate to make an initial estimate of the tax liability. However, it's important to note that this rate is not final and may need to be adjusted based on the employee's annual income and tax situation.

Federal Income Tax and FICA

In addition to the withholding rate, severance pay is subject to other federal and state taxes. For federal income tax, the current withholding rate of 22 percent applies. However, this rate is just an estimate, and the actual tax amount may differ when the employee files their tax return.

Severance pay is also subject to the Federal Insurance Contributions Act (FICA) taxes, which include Social Security and Medicare taxes. Social Security tax for 2023 is 6.2% applied to the first $160,200 of wages, while Medicare tax is 1.45% with no wage limit. In the case of severance pay, only the social security tax (up to $160,200) applies. However, since severance is not subject to Social Security tax caps, the full amount of severance pay will be included in the Medicare tax calculation.

State and Local Taxes

State and local taxes can also apply to severance pay. The specific tax rates and rules can vary significantly based on the state and city where the employee is located. Employees should consult with their tax advisor or the relevant state tax authority to determine the applicable withholding rates for state and local taxes.

Adjusted Withholding and Final Settlement

After the severance payment is made, the employer will provide the employee with a Form W-2, which summarizes the total income for the tax year, including severance pay. This form is then used to calculate the employee's final tax liability.

It is possible that the initial withholding rate may need to be adjusted during the year based on changes in the employee's annual income or other factors that affect their tax bracket. Additionally, if the total severance pay exceeds the annual cap for Social Security tax, the excess may need to be reported to the IRS and covered in a final settlement.

Potential for Tax Credits and Deductions

Employers and employees must also be aware of potential tax credits and deductions that can affect the tax impact of severance pay. For example, if an employee takes early retirement, they may be eligible for certain tax breaks.

Conclusion

In summary, severance pay in the United States is subject to federal income tax, FICA taxes, and potentially state and local taxes. The withholding rate of 22 percent serves as an initial estimate that may need to be adjusted. Employers must accurately report severance pay to the IRS using Form W-2 and employ a tax professional to ensure compliance with varying state and local tax laws. Proper planning and communication can help minimize the tax impact for both employers and employees.

Keywords

Keywords: severance pay, supplemental wages, withholding rate, federal income tax, FICA