Severance pay is taxed as ordinary income, and your employer must withhold federal income tax, Social Security tax, and Medicare tax from it

When you receive severance, the IRS treats it the same way it treats your regular wages. Your employer withholds taxes based on the amount you receive and the W-4 form you have on file. The withholding happens at the time you get the payment, not later. If your employer does not withhold enough, you will owe the difference when you file your tax return.

The tax rate depends on your total income for the year, your filing status, and your state of residence. Severance does not get a special tax rate or exemption — it counts as taxable income in the year you receive it. If you receive a large severance, you may jump into a higher tax bracket, which means some of that money will be taxed at a higher percentage than your regular paychecks.

Key Takeaways

  • Severance is taxed as ordinary income at federal, state, and sometimes local levels, with withholding taken at the time of payment.
  • Your employer uses your W-4 form to calculate withholding, so updating it before severance is paid can affect how much is withheld.
  • A large severance payment can push you into a higher tax bracket for that year, increasing your effective tax rate on the total amount.
  • You may owe additional taxes at tax time if your employer did not withhold enough, or you may receive a refund if too much was withheld.
  • Certain severance components like unused vacation or sick leave are taxed as wages, while damages for wrongful termination may not be taxable depending on the reason.

Federal income tax withholding on severance

Your employer calculates federal withholding using the amount of severance, your W-4 form, and IRS withholding tables. If you receive severance as a lump sum, your employer may treat it as a single large paycheck and withhold at a higher rate than your normal paychecks. This is called the aggregate method of withholding.

You can reduce the amount withheld by updating your W-4 before the severance is paid. If you know you will receive severance in a particular month, you can claim additional allowances on a new W-4 to lower the withholding. However, this only works if you submit the new W-4 before your employer processes the severance payment. Once the payment is made, the withholding is final unless you file an amended return.

If your employer withholds too much, you will receive the overage as a refund when you file your tax return. If too little is withheld, you will owe the difference. The IRS does not charge penalties for underpayment of estimated taxes if your total withholding for the year is at least 90 percent of your current year tax liability or 100 percent of your prior year liability (110 percent if your prior year adjusted gross income was over $150,000).

Social Security and Medicare taxes on severance

Severance is subject to FICA taxes — Social Security tax at 6.2 percent and Medicare tax at 1.45 percent — up to the annual Social Security wage base. For 2024, the Social Security wage base is $168,600, meaning you pay Social Security tax only on severance up to that amount in a single year. Medicare tax applies to all severance with no cap.

If you have already earned wages up to the Social Security wage base earlier in the year, your severance will not be subject to Social Security tax. Your employer's payroll system tracks this automatically. However, you will still pay Medicare tax on the full severance amount.

Self-employed individuals do not receive severance, so FICA withholding applies only to employees. If you are classified as an independent contractor, your severance (if any) would not be subject to FICA taxes, though you may owe self-employment tax depending on how the severance is structured.

State and local income tax on severance

Most states that have an income tax will tax severance as ordinary income. Your employer withholds state tax based on your state W-4 form and your state's withholding rules. Some states have different withholding methods or rates for lump-sum payments, so the amount withheld may differ from what you expect.

Nine states have no income tax: Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, Wyoming, and New Hampshire (which taxes only dividends and interest, not wages). If you live in one of these states, you will not owe state income tax on severance, though your employer may still withhold if you previously lived in a state with income tax.

Some cities and counties impose local income taxes. New York City, for example, taxes severance at the local level in addition to state and federal taxes. If you work or live in a jurisdiction with local income tax, your employer should withhold it from severance. Check your pay stub to see whether local tax was withheld.

How severance affects your tax bracket

Severance is added to all other income you earn in the same calendar year. If you receive a large severance, your total income for the year may be significantly higher than usual, which can push you into a higher tax bracket. This means the severance itself is taxed at a higher rate than your regular paychecks would be.

For example, if you are single and earn $50,000 in regular wages, you are in the 22 percent federal tax bracket for 2024. If you receive a $30,000 severance, your total income is $80,000, which puts you in the 24 percent bracket. The severance is taxed at 24 percent, not 22 percent, because it is the income that pushes you over the bracket threshold.

This bracket effect is temporary — it applies only to the year you receive the severance. In the following year, your income returns to its normal level and your tax bracket adjusts accordingly. Some people spread severance over two years by negotiating with their employer to receive part in December and part in January, though this requires agreement from both sides and may not be possible.

Taxable and non-taxable severance components

Most severance is fully taxable, but certain components may have different tax treatment. Unused vacation and sick leave paid out as severance are taxed as wages. Accrued bonuses are also taxed as ordinary income. These are all withheld and reported on your final W-2 form.

Damages for wrongful termination or discrimination may not be taxable if they are awarded by a court or settlement agreement specifically for physical injury or sickness. However, damages for emotional distress, lost wages, or breach of contract are taxable. The tax treatment depends on the reason for the damages and how they are characterized in the settlement agreement. If you receive a settlement, your employer or the paying party should provide a Form 1099 or note on your W-2 indicating what portion, if any, is taxable.

Outplacement services (career counseling, resume writing, job search information) provided by your employer are generally not taxable to you if they are provided by a third party on your employer's behalf. However, if your employer gives you cash to pay for outplacement yourself, that cash is taxable income.

Reporting severance on your tax return

Severance appears on your Form W-2 in Box 1 (wages, tips, other compensation) and Box 5 (Medicare wages and tips). The total in Box 1 includes your regular wages plus severance. Your employer must send you the W-2 by January 31 of the following year.

When you file your tax return, you report the amount from Box 1 of your W-2 as wages on Form 1040, line 1a. You do not file a separate form for severance — it is included in your total wage income. If you received multiple W-2 forms (from different employers or from the same employer if you changed jobs), you add up all the amounts from Box 1 across all W-2s.

If your employer withheld too much tax, you will receive a refund. If too little was withheld, you will owe additional tax. You can estimate this by calculating your total tax liability for the year and comparing it to the total withholding shown in Box 2 (federal income tax withheld) on your W-2.

What to do if withholding was incorrect

If you believe your employer withheld the wrong amount of tax from your severance, you have options. First, check your pay stub and W-2 to confirm the amounts withheld. If the withholding is incorrect, contact your employer's payroll department and ask them to review it. If the error is their mistake, they may issue a corrected W-2 (Form W-2c) before you file your return.

If you file your return before discovering the error, you can file an amended return using Form 1040-X. You have three years from the original due date of your return to file an amendment. If you are owed a refund due to overwithholding, filing an amendment will allow you to claim it. If you owe additional tax due to underwithholding, you should file the amendment to avoid penalties and interest.

If you expect to owe a large amount of tax because of severance, you can make an estimated tax payment to the IRS before the end of the year. This reduces the amount you will owe at tax time and may help you avoid underpayment penalties. Estimated payments are made using Form 1040-ES and can be submitted online through the IRS website or by mail.

Frequently Asked Questions

Is severance taxed differently than regular wages?

No. Severance is taxed as ordinary income at the same federal, state, and local rates as regular wages. The only difference is that a large lump-sum severance payment may be withheld at a higher rate because your employer calculates withholding based on the total amount in a single paycheck.

Can I avoid taxes on severance by deferring it to the next year?

Not unless your employer agrees to pay it in a future year. Severance is taxable in the year you actually receive it, regardless of when the employment ended. If you negotiate to receive part of your severance in January instead of December, that portion is taxed in the following year, but you cannot avoid taxes entirely.

What happens if my severance pushes me into a higher tax bracket?

The severance is taxed at the higher bracket rate for the portion that exceeds the threshold. Your total tax liability increases, but only on the income above the bracket line. This is a temporary effect that applies only to the year you receive the severance.

Do I have to pay self-employment tax on severance?

Only if you are self-employed or classified as an independent contractor. Employees pay FICA taxes (Social Security and Medicare) through withholding. Self-employed individuals do not typically receive severance, but if they do, it would be subject to self-employment tax depending on the structure of the payment.

Will I get a refund if too much tax was withheld from my severance?

Yes. When you file your tax return, the IRS compares your total withholding to your actual tax liability. If more was withheld than you owe, you receive a refund. The refund is issued to you, not to your employer.