While it’s always challenging to lose your job, the severance package offered by your employer can soften the blow. However, before accepting a lump sum severance payment, it’s worth considering the benefits of requesting to spread out your severance package over a longer period. And this tip is not just about making your payout last longer for the recently laid off. Because severance pay is taxed as ordinary income, distributing it out over time is an easy way to keep yourself in a lower tax bracket.
If you recently lost your job, here’s what to know about how your severance will be taxed and how you can make the most of your severance package.
Is severance pay taxed?
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Severance is taxed just like ordinary income, at the ordinary income tax brackets. This means you’ll pay federal income taxes, Social Security, Medicare, and federal unemployment tax on your severance pay, just as you would for your regular wages. So while you can’t (legally) avoid taxes on your severance package, there are ways to strategically minimize your tax burden.
Why spread out your severance package?
Spreading out your severance package offers several advantages that can help you manage your finances more effectively:
If you want to pay fewer taxes, you should have your severance paid out in two separate years. If you’re expecting a lower income in the following year, it might be advantageous to delay the payment until then to lower your tax bracket for this year. Otherwise, receiving a single large lump-sum payment now could push you into a higher tax bracket.
If your severance pay includes a pension or retirement plan distribution, consider rolling it over into an eligible tax-advantaged account. This might be your IRA, 401(k), or even HSA. This move can help you defer taxes on that portion until you withdraw the funds in the future.
Extended health coverage
Many severance packages include health insurance coverage for a specific duration. By spreading out the package, you could prolong your access to these benefits.
Steady income stream
Opting for periodic payments ensures a consistent income stream, helping you maintain financial stability over an extended period. And with that stability comes the freedom to take your time to find the right job opportunity, rather than rushing into a decision due to financial pressures.
Tips for spreading out your severance package
Carefully read through the terms of your severance package to understand the lump sum amount offered, the potential duration of the payments, and any other benefits included.
Consider drafting a formal proposal outlining your reasons for requesting a spread-out severance package. Emphasize the benefits to both you and the company, such as reduced tax liability and the assurance of a dedicated employee during any existing transition period.
Be prepared for negotiation. Your employer may have their own concerns, so be flexible and willing to find a middle ground that satisfies both parties. Once an agreement is reached, ensure all the details are documented in writing. This will serve as a reference point to avoid misunderstandings in the future.
The bottom line
Requesting to spread out your severance package can be a strategic move that benefits both your financial stability and the company’s transition process. While there is no way to completely avoid paying taxes on severance, you can be proactive and reduce the amount of severance that will be taxed. Make sure you get advice from a financial professional so you get the best possible tax benefits for your personal situation.