A Tax Guide to Severance Packages and Taxes

You may wonder about the tax implications if you’ve recently been laid off and received severance pay. It’s understandable that taxes may be the last thing on your mind during a difficult time, but knowing how severance pay is taxed can help you better manage your finances and avoid a worse situation.

In this article, we’ll answer common questions about receiving severance pay and how it may affect your taxes. We’ll also provide some tips on how you can potentially lower your tax bill.

Is Severance Pay Taxable?

Yes, severance pay is taxable income and is subject to federal, state, Social Security, and Medicare taxes. This means that if you receive severance pay, you will need to report it on your tax return for the year in which you received it.

Like your regular paycheck, your employer will withhold some taxes from your severance pay. The amount withheld will depend on how your employer pays out your severance.

If your severance pay is part of your regular wages, then the normal tax withholding that applies to your paycheck will also apply to your severance pay. If your employer pays out your severance separately from your regular wages, then a flat 22% withholding rate for federal income tax will generally apply.

Keep in mind that the taxes withheld from your severance pay may not cover your entire tax liability. Depending on your individual tax situation, you may owe additional taxes or be eligible for a refund. To avoid any surprises at tax time, we recommend speaking with a tax professional who can help you adjust your withholdings or make estimated tax payments if needed.

Can You Collect Unemployment if You Receive Severance Pay?

Whether or not you can collect unemployment benefits while receiving severance pay will depend on the state you live in and other factors. Each state has its own requirements for unemployment benefits, and in some states, you may not be eligible to collect unemployment until after your severance period has expired.

It’s important to note that unemployment benefits are also taxable income. If you do file for unemployment, you can request tax withholding to help offset your tax liability.

How Else Could Severance Pay Affect Your Taxes?

The additional income from your severance pay could bump you into a higher tax bracket, increasing your tax liability. For example, if you receive six months of severance pay in November, you will effectively receive 17 months’ worth of pay during that tax year.

Keep in mind that moving into a higher tax bracket doesn’t mean that all of your income is taxed at that rate. The US tax system is progressive, meaning that your tax rate increases as your income increases. So, if your severance pay pushes you into a higher tax bracket, only the portion of your income that falls into that bracket will be taxed at the higher rate.

Additionally, having more income may also impact your eligibility for certain tax credits and deductions. If you’re concerned about the tax implications of your severance pay, you may be able to lower your taxable income by making additional contributions to a health savings account (HSA) or an individual retirement account (IRA) if you’re eligible.

What Other Tax Impacts Are There After Experiencing Job Loss?

Losing your job often means losing your health insurance, but job termination is considered a qualifying event that allows you to enroll in a health insurance plan through the marketplace. Depending on your income, you may be eligible for the advance premium tax credit, which can help lower your monthly insurance premiums.

If you had a flexible spending account (FSA) through your employer, you may forfeit those funds when you lose your job unless you continue coverage using COBRA. COBRA stands for Consolidated Omnibus Budget Reconciliation Act. It's a federal law that requires certain employers to offer continued health insurance coverage to employees and their dependents who lose their health benefits due to job loss or other qualifying events, such as reduced work hours or divorce. COBRA coverage typically lasts for up to 18 months, although it can be extended under certain circumstances. However, COBRA coverage can be expensive, as the employee is responsible for paying the full premium cost, plus a 2% administrative fee.

File your taxes with Taxfyle

Dealing with a financial setback is tough, and severance or unemployment income can be a crucial source of support during those times. However, figuring out how these types of income affect your taxes can be complex and overwhelming. Luckily, you don't have to face this challenge alone.

Taxfyle connects you with one of its experienced CPAs or EAs within its Pro network. You can rely on Taxfyle to help you navigate your taxes and maximize your tax refund. With Taxfyle's innovative app, tax filers can easily connect with licensed CPAs and EAs who can offer personalized guidance and support every step of the way.

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