How Is Severance Pay Taxed: 2025 Guide

Hearing the words, "you're being laid off," can bring on one of the worst feelings in the world. After all, if you're like most people, you probably count on your job to provide you with a paycheck, not to mention health insurance and other valuable benefits. Without work, you may fear you'll end up borrowing and end up needing debt relief down the line.

When you find yourself in this tough situation, you have a lot of practical things to think about, including figuring out how severance pay is taxed. 

Many employers offer a severance package, which can include things like payment of your past salary for a set period of time, continuation of employee benefits for a limited time, and even perks like career assistance to find your next job. 

You might owe taxes on your severance pay (unemployment benefits are also taxable). If it's taxable, you'll have to pay FICA taxes (Medicare and Social Security taxes), and state income taxes, all of which can take a big bite out of the severance payment that's supposed to see you through your unemployed era. 

This article will explain the key details about how severance pay is taxed and how severance pay works in general, so you can understand what to expect, make informed choices, and take financial control of your situation with smart tax planning.

Understanding Severance Pay Taxation Basics  

Understanding how taxes on severance pay work is important to try to reduce the taxes you owe. Keeping those costs down makes it less likely you'll need tax debt relief in the future, so it's worth learning the details.  

According to the IRS, you must include severance pay as part of your taxable income. Like your regular income, severance pay may be subject to a few different taxes:

• Income tax: This is based on the income tax rate for the amount you made that year.

• Social Security tax: Social Security is taxed at a rate of 12.4% on income up to $176,100 in 2025. Half of this is paid by the employer, and half by the employee. 

• Medicare tax: This is a 2.9% tax, which is also split 50-50 between the employer and you. High-income employees may have an additional 0.9% Medicare tax paid by their employer.

• Federal unemployment tax: This is paid by your employer.

• State tax: If your state charges an income tax, severance pay is treated as income, and you will be taxed on it. 

Since severance pay is taxed as ordinary income, the rate you pay on it depends on the amount of money you made over the course of the tax year. This includes:

• Any regular pay you earned before you lost your job

• Severance pay

• Unemployment benefits

• Income from other sources such as investments

Unemployment benefits count as income, but other types of government assistance, such as SNAP benefits, aren’t taxable. 

Taxes must be paid as you go in the United States, and employers generally withhold a set amount from your pay based on information you submitted on your W-4 form when you were hired (even so, you are responsible for paying taxes whether they are withheld or not). 

The amount withheld from severance pay may be different from the percentage of your wages that was being withheld from your paycheck when you were working, as taxes depend on how large your severance payment is and how the payment is structured. 

When you receive your W-2 tax form from your employer at the end of the tax year, the severance pay you received will be reported as regular wages and added to the total wages for the year, which is found in Box 1. You may owe more tax on your severance pay, or get a refund on some of the taxes that were withheld, depending on your total income during the year.

Your job loss could trigger tax on your retirement savings

If you had a retirement plan through your former employer, the loss of your job could also potentially have tax implications. 

Generally, when you leave your job, you can leave your 401(k) with your old employer. If the balance is under $5,000, though, you may have to move the money out of the employer’s plan. 

In that case, you’ll have 60 days to roll the money over into another qualified retirement plan, such as an IRA. If you miss that deadline, the money is treated as a taxable distribution from the plan. That means you’ll owe taxes on it, and a 10% early withdrawal penalty if you’re younger than 59 1/2. 

A distribution could increase your income even more for the year, increasing the chances you're pushed into a higher tax bracket and charged at a higher rate. You'll want to avoid that by making sure that you are proactive in planning for your retirement funds. 

You May Like These

How Does Student Loan Forbearance Affect Your Credit Score?

Should You Go Debt-Free? Pros and Cons of Debt-Free Living

Mortgage Vocabulary: Terms You Need to Know

Why Severance Might Be Taxed at a Higher Rate  

When your employer withholds taxes from your severance pay, the taxes could be withheld at a higher rate than you were having withheld from your regular wages.

The specifics of how much is withheld will depend on how your employer classifies the payment. Severance pay can either be classified as supplemental wages or ordinary income, and this affects the taxes that are withheld from your payment.  Here's what happens with each of these options:

• Severance pay may be treated like supplemental wages. If so, you’ll have 22% withheld for federal taxes.

• Severance pay may be treated like regular wages. If so, withholding is based on tax rates that apply to a check of that size. If you receive your severance pay as a lump sum, the check may make it appear that you are in a higher tax bracket. This means a larger percentage of your check could be withheld than you are expecting. 

You do not get to decide how your employer treats your severance check—the company does. 

It's important to note that the rate at which taxes are withheld is not necessarily the rate that you will pay. You are ultimately always going to be taxed at your ordinary income tax rate on your severance pay. This could be the same, higher, or lower than the rate at which taxes are withheld. 

You should also know that receiving a large severance payment could also push you into a higher tax bracket for the year by increasing your total taxable income. This would mean some of your income is actually taxed at a higher rate than you are used to. 

A higher income could also affect your eligibility for certain means-tested deductions such as the Earned Income Tax Credit, the deduction for student loan interest, and the child tax credit. You should consider what your total taxable income will be for the year to understand what your tax rate is and how your severance will be taxed. 

Comparing Payment Methods: Tax Implications  

When you negotiate your severance package, you may want to talk to your employer about how the payments are structured, as you have a few options and your choice could affect your tax rate. 

Options include:

• Spread out payments. Talk to your employer and ask if the severance pay can be paid to you in installments over two years, instead of as a big lump sum. Less income in one year could keep you in a lower tax bracket.

• Delayed payment. If you’re due to receive a lump sum toward the end of a calendar year, you may want to ask if it could be delayed until after January 1. If you’ve already earned almost a full year’s worth of wages, getting severance pay on top of that may bump you into a higher tax bracket. The severance pay may have less tax impact in the new year, especially if you end up unemployed for a while. 

• Lump sum. Your employer may want to pay you in a big lump sum. This outcome is more likely to result in you being pushed into a higher tax bracket since you are receiving a large amount of taxable income at one time. 

Here's an example of how different payment methods could affect the taxes owed. 

Ruben learns in November that he’s going to be laid off before the end of the year. His employer offers him six months of pay as a severance package to be paid as part of his last paycheck. He has already earned 11 months of wages this year. Adding his severance to his income would mean being taxed on 17 months of income this year, which would put him into a higher tax bracket. 

Having the severance added to his last paycheck could also mean that withholding would be calculated as if he earned that amount every pay period. 

If Ruben asks his employer to pay his severance in installments over the next six months instead, this would prevent him from getting pushed into a higher tax bracket this year. It also means he won’t have an unusually large paycheck that triggers a higher withholding rate.

State-Specific Severance Tax Considerations  

You may also have to pay state taxes on severance pay. The majority of states charge income tax, and this income tax will typically apply to severance pay as well. 

If you live and work in the same state, then you'll just pay taxes to that state. However, if you live and work in different states, things become complicated.

Some states require you to pay tax on severance pay for work performed in that state, even if you live elsewhere. If that's the case, the state where you live should give you a credit for the taxes paid to the other state where you worked. 

States may also have reciprocity agreements that allow you to be taxed where you live versus where you work. These agreements may apply to severance pay as well if the state treats severance pay as wages from work, so if one of these agreements applies, your severance pay will also be taxed in the state where you live. 

Because of the complexities involved, you should get help from a tax professional if you receive a severance payment for work performed in a state that is different from the one you live in. 

You should also be aware that some localities charge local income taxes that could apply to severance pay. Everybody’s tax situation is a little different, but here’s an example of how this might work:

• Suppose you’re a single taxpayer in New York City and you’re laid off with a $10,000 severance payment that’s paid all at once.

• Before that, you earned $40,000 in regular wages during the year.

• As a New York City resident, you’d be subject to New York State and New York City income taxes, as well as federal income taxes.

• The rate for all those taxes would be based on $50,000 a year (the combined total of your regular wages and severance pay).

• The federal, New York State, and New York City tax rate for a $50,000 earner would be applied to your $10,000 severance pay. 

Of course, not all states and cities have income taxes.  Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming do not charge income taxes, so you will not be taxed on your severance pay in these states. 

Strategies to Reduce Severance Tax Burden  

You can’t change the tax laws, but you may be able to affect how they apply to your severance pay.  That's because there are strategies to reduce your tax bill.

As mentioned above, if you’re able to, negotiating the method and timing of your severance payouts and your tax deductions could affect how much tax is taken out of your severance pay. You can also make some financial moves that will provide you with offsetting deductions to reduce how much tax you pay—especially if you are pushed into a higher tax bracket due to your severance check.

Examples include:

• Contribute to a health savings account (HSA) if you are eligible for one. You can make HSA contributions if you have a qualifying high-deductible health plan. These accounts allow you to save money for future healthcare expenses on a tax-advantaged basis. Your money grows tax-deferred, contributions are tax-deductible, and withdrawals are tax-free when used for qualified medical expenses. 

• Increase charitable donations. Making deductible contributions could be a way of lowering your tax bracket in the year you receive your severance. This only works if you itemize your tax deductions. 

• Boost retirement savings. If you can afford it, put some of your severance pay into a retirement account. That could lower your taxable income, with the bonus of helping your nest egg grow.

• Pay for education. New skills or credentials could help you get your next job. Education costs may be tax-deductible. If you use your severance pay for school or training programs, you might not have to pay taxes on that money.

• Deduct mortgage interest. Interest is deductible on loans up to $750,000 if you itemize on your taxes.

Here's an example of how this could work. Cherise gets laid off in September, with a month of severance pay. That severance check would put her in a higher tax bracket. Rather than face a higher tax rate on her severance pay, Cherise decides to contribute that money to a traditional IRA. This allows her to defer taxes on her severance pay, avoid the higher tax rate, and give her retirement savings a boost.  

Your eligibility to offset income with these deductions depends on your situation. Tax rules change from year to year, so it's a good idea to talk to a qualified tax professional about your situation and ask how much tax you'll owe on your severance pay.

You may also become eligible for new deductions if your income falls due to unemployment, such as the Earned Income Tax Credit. Working with a tax professional can help you understand your options.

Severance pay vs. other post-employment income

You might receive both severance pay and unemployment benefits when you lose your job. These aren’t the same, and they don’t come from the same source. Here are the main differences:

• Source: Severance pay is from your employer when you're laid off. Unemployment benefits come from the state, although your employer pays to fund the program.

• Taxes: Severance pay is taxable income and is taxed like wages. Unemployment is taxable, but some states don’t tax unemployment benefits. 

• Impact on benefits: Some states reduce your unemployment benefits if you receive severance pay because severance pay is income. Unemployment, however, has no effect on severance. 

• Duration and amount: Severance pay is often a one-time payment. Unemployment benefits typically last for a set number of weeks, depending on where you live. (Often, it lasts for a maximum of 26 weeks.) During that time, you may have to fulfill your state’s requirements, such as by searching for a new job.

You may also have sources of income after being laid off as well, such as pension distributions, a payout of your vacation or PTO, and stock options. It's important to understand the tax rules for these types of income. 

If you withdraw money from your pension, for example, this is usually considered taxable income unless you put the funds into another qualifying retirement plan. PTO and vacation payouts are taxable as well as supplemental wages. If you're allowed to keep your employer health insurance under COBRA, that benefit is not taxable, but salary continuation plans are. 

If you cash in equity or stock options, on the other hand, this may be treated as investment income and you may be subject to short-term or long-term capital gains taxes 

Because this can be very complex, you should consider talking to a tax professional if you have multiple income sources after a layoff. 

What If You Can’t Pay What You Owe?

Losing your job can put stress on your finances. It can also create an unfamiliar tax situation for you. The combination of the two may mean that, come tax time, you find yourself unable to pay your taxes.

If that happens, don’t ignore the problem. If you contact the IRS for help, they may have a solution for you. They may agree to allow you to pay your taxes in installments. They may also delay when payments are due. 

If you absolutely have no way of paying what you owe, the IRS may agree to accept a lesser amount. If you simply ignore the problem, the IRS may be less inclined to help you find a solution. You could get hit with fines and other penalties that make the problem worse. 

Managing other debts after a layoff

Managing other bills after a layoff can also help you to ensure you can afford your taxes from severance. For example:

• If you have a substantial amount of credit card debt, a debt management plan or debt settlement program could help you to pay it back more easily. After paying it back, consider whether you should go debt-free so you won't have to worry about payments in the future. 

• If you owe money on your student loans, consider student loan deferment or forbearance. While you'll want to understand how student loan forbearance affects your credit score and total payoff costs, being able to pause payments temporarily could help you make ends meet during periods of unemployment. 

• Talk to your mortgage lender. Mortgage forbearance or hardship programs could also make covering your home loan more affordable. 

If you have an emergency fund, you can also rely on that money to help cover the bills and taxes due. Ultimately, though, finding the right way of dealing with taxes on severance payments can do more than just save you money. It can help you start the next phase of your career without a tax problem.

Managing Payments and Debt After a Layoff 

Leaving a job is a major financial change. If you find yourself struggling, Freedom Debt Relief is here to help. Freedom Debt Relief can help you to make a proactive plan for managing your debt so you can ensure your finances are in a good place and you're able to pay taxes due on your severance.

Freedom Debt Relief has offered guidance and support to many people seeking debt help. Contact us today to learn more so you can develop your post-layoff financial plan.