Economic downturns often result in layoffs, particularly in industries like tech. For some employees, the bright spot in these challenging times is a severance package. If you’ve received one, it’s natural to feel overwhelmed. While taxes may not be top of mind, understanding their impact on your severance can help you manage finances and prepare for tax season.

Is Severance Pay Taxable?

Yes, severance pay is taxable in the year you receive it. This means that if you’re receiving a few months of severance, you should expect taxes to reduce the total payout.

Here’s how taxes may be applied:

• As Part of Regular Wages: Some employers treat severance as regular wages, applying typical withholdings like federal and state income taxes, Social Security, and Medicare.
• Separate Payment: Other employers may pay severance separately, applying a flat 22% federal withholding rate instead of using your W-4 to calculate withholdings.

If you’ve accumulated unused vacation or sick pay, those payments may also be taxed similarly. Just remember, withholdings may not cover all your tax obligations, so it’s wise to evaluate whether additional tax payments or adjustments are needed to avoid surprises.

Can You Collect Unemployment with Severance?

Your eligibility for unemployment benefits alongside severance will depend on your state, the severance amount, and duration. Some states may only allow you to collect unemployment after your severance period ends. Contact your state’s unemployment office to confirm your eligibility and file a claim.

Keep in mind: unemployment benefits are also taxable. If you do apply, consider requesting tax withholdings to cover some of these obligations.

How Severance Pay Can Affect Your Taxes

Receiving severance can lead to a larger-than-usual income for the year, potentially moving you into a higher tax bracket. For instance, a six-month severance package received in November could mean receiving 17 months’ worth of income in one tax year.

Things to consider:

• Higher Marginal Tax Rate: The U.S. has a progressive tax system, so only the portion of income above certain thresholds is taxed at higher rates. This means severance pay could push a portion of your income into a higher bracket, increasing your marginal tax rate.
• Phase-Outs for Credits or Deductions: Higher income could also make you ineligible for certain tax credits or deductions tied to income thresholds.

To mitigate these impacts, consider making contributions to tax-advantaged accounts like an HSA or IRA if you qualify, which could reduce your taxable income.

Additional Tax Implications After Job Loss

Job loss often means a loss of employer-provided insurance. Fortunately, losing your job qualifies you for a special enrollment period for marketplace insurance, potentially making you eligible for premium tax credits to help with coverage costs.

If you have a health Flexible Spending Account (FSA) through your employer, keep in mind that these funds are generally forfeited unless you continue coverage under COBRA.

Navigating Taxes with Professional Help

Severance and unemployment benefits are vital during financial setbacks but can complicate your taxes. Your partners at PSA CPA are available to help you navigate these complexities, so you can maximize your benefits and reduce tax burdens.