If you’re like many Americans this year, you might find yourself in the fortunate position of receiving severance pay and are wondering how you can reduce taxes on it. While the Fair Labor Standards Act does not require employers to pay any severance money to employees when they exit a company, more and more companies are adopting this practice.
What is severance pay?
A severance package, though it sounds extravagant, is often a nice but small amount of money a company gives employees who are involuntarily leaving the company for any number of reasons. Generally a severance package will be equal to about a week or two of pay for every year you’ve been with the company. For instance, if you’re in your first year of employment when you leave, you may be offered 2 weeks worth of pay. If you have worked with a company for 5 fives, you may be offered 10 weeks worth of pay.
Here’s a cool tip I’ll explain below: You can negotiate for MORE severance!
Who gets severance?
Because there are no laws requiring employers to pay severance, there’s no standard expectation for who receives it and when. However, here are the top reasons an employer may offer severance pay:
- You are being let go for under-performing.
- The company has been acquired and they are reducing the number of employees in the reorganization.
- Your company may offer it in exchange for getting you to agree you won’t sue for wrongful termination.
- It may be offered in exchange for you to sign a non-disparagement clause. Signing a non-disparagement clause means you promise not to say anything negative about the company or its products, services, or leaders.
If you are being let go or think you may be let go soon, talk to your employer about a severance package. You do not have to wait for them to bring it up to you. To increase your chances of receiving severance, always handle these conversations professionally and without emotion.
What are the steps to ask for severance?
- Prepare a list of your accomplishments in advance so you can argue your case with data
- Be ready to agree to an exit interview.
- Let them know you are willing to sign a non-disparagement agreement in exchange for severance.
If your company is automatically offering you a severance package, you can negotiate for more! Most people never realize this. You have a lot of bargaining power especially if they are asking you to sign non-disparagement agreements or an agreement not to sue them for any reason. Always ask for at least DOUBLE the severance pay during your negotiations.
Never sign a severance package on the spot. Always take a couple of days to consider it. Keep in mind that if you’re over 40 years old, federal law requires that you be given at least 21 days to sign. Use this time to your advantage. You can negotiate more than just the amount of money – you can even ask for help with services like job placement!
How can I reduce the taxes I owe on my severance?
The IRS considers severance pay to be supplemental wages and is included in Box 1 of your Form W-2 (the box that includes wage and salary income). Because of this, your employer will withhold federal and state taxes on your severance pay. There are several really smart ways you can reduce the taxes you’d have to pay on your severance, which is important because severance is often paid in a one time lump sum payment – which can result in a pretty significant tax burden!
- Spread out your payments: You can ask your employer to split your severance payment and pay it over the course of two calendar years. This is a smart move especially if the single larger amount would put you in a higher tax bracket for the current year.
- Direct your severance into an IRA: As of 2022 you can put $6,000 in an individual retirement account. Money put into an IRA isn’t taxed until you withdraw it during retirement. If you need some of your severance immediately to live on and make ends meet, consider putting a portion of it into an IRA.
- Put the funds in an HSA. Do you have a high deductible health insurance plan? If not, you should strongly consider using one. I detail the advantages of it here.
- Considering going back to school? Taking some more courses? Have children who may attend college? You can reduce your tax burden on your severance by putting some or all of it into a 529 plan. Did you know that if you have a 529 plan for your child, you can actually use those funds for any family member? You can put your severance into a new or existing 529 and then use that money to take courses and get additional job skills for yourself.
- Do you have a HELOC (home equity line of credit)? If you don’t, you should! And if you do, you probably already know the many financial hacks it facilitates. If you have a HELOC, dump your severance into the HELOC – even though it won’t lower your tax burden like the options above, a large sum of money in your HELOC can drastically reduce to interest you’ll pay on your home, saving you money! Plus, you’ll have access to the severance money for living expenses while it’s paying down your home.
As you can see, there are several ways to reduce the amount of taxes you’ll pay on your severance. If you find yourself being let go, remember to ask for severance and negotiate for yourself. These days employers care about their image, as it has become harder to find and retain employees – therefore, many companies are now more amenable to offering severance pay. Don’t leave potential money on the table!
As always, stay happy. If your life is a mess, let’s sort through it together!
Disclaimer: Just My Little Mess does not provide tax, investment, or financial services and advice. The information is presented without considering the investment objectives, risk tolerance, or financial circumstances of any specific investor. It might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.