Severance pay is taxable income, but the tax you owe depends on how your employer structures the payment and whether you roll it into a retirement account

The IRS treats severance as ordinary income. Your employer withholds federal income tax, Social Security tax, and Medicare tax from the payment just as they would from regular wages. You cannot avoid the tax entirely, but you can reduce what you owe by moving part of the severance into a tax-deferred retirement account before you receive it, or by timing the payment across two calendar years if your employer allows it.

The most common way to reduce severance tax is a direct rollover into an IRA or your new employer's 401(k) plan. If your employer pays part of your severance directly to a retirement account instead of to you, that portion is not subject to income tax withholding at the time of payment. You still owe tax eventually when you withdraw the money in retirement, but you defer it for decades.

Key Takeaways

  • Severance is taxed as ordinary income, and your employer must withhold federal, Social Security, and Medicare taxes unless you direct part of it into a retirement account.
  • A direct rollover to an IRA or 401(k) lets you defer tax on the portion you roll over, though you must complete the rollover within 60 days if you receive the check yourself.
  • If you receive severance in two separate calendar years, each year's amount is taxed separately, which may lower your tax bracket for the year you receive less money.
  • Unused vacation or paid time off paid out as severance is taxed the same way as severance itself and cannot be rolled over into a retirement account.
  • Your employer's withholding is an estimate; you may owe more tax or receive a refund when you file your tax return, depending on your total income for the year.

How direct rollovers reduce your tax bill

A direct rollover means your employer sends severance money directly to a financial institution holding an IRA or 401(k) account in your name, rather than sending it to you. The money never touches your hands. Because you do not receive it, the employer does not withhold income tax on that amount.

You can roll over severance into an IRA (Individual Retirement Account) at any bank, brokerage, or credit union that offers them. You can also roll it into your new employer's 401(k) plan if that plan accepts rollovers, which most do. Ask your new employer's benefits department whether their 401(k) accepts incoming rollovers before you negotiate severance with your old employer.

The amount you can roll over is limited only by the severance your employer is willing to pay you. There is no annual cap on rollover contributions the way there is on regular 401(k) contributions. However, if you have taken a loan against a 401(k) from your old employer, you may have to repay it before rolling over severance into an IRA.

What happens if you receive the severance check yourself

If your employer writes you a check for the full severance amount, they must withhold taxes before handing it to you. The check you receive is smaller than the severance amount. You then have 60 days to roll the after-tax portion into an IRA or 401(k) if you want to defer tax on part of it.

This is called an indirect rollover, and it is more complicated than a direct rollover. You receive the full severance amount (before withholding), but your employer also sends a separate check to the IRS for the withheld taxes. You must deposit your portion into a retirement account within 60 days, or the IRS treats it as a distribution and you owe income tax on the full amount plus a 10 percent early withdrawal penalty if you are under 59½.

The 60-day clock starts the day you receive the check, not the day your employer issues it. Weekends and holidays count toward the 60 days. If the 60th day falls on a weekend or holiday, you have until the next business day. Many people miss this important date by accident, so mark your calendar when ready when you receive the check.

Splitting severance across two tax years

If your employer allows it, you can negotiate to receive part of your severance in the current calendar year and the rest in the next calendar year. This splits your income across two years, which may lower your tax bracket in each year.

For example, if you are laid off in November and your employer offers $100,000 in severance, you might ask to receive $50,000 before December 31 and $50,000 after January 1. Each $50,000 payment is taxed separately based on your other income that year. If you have little other income in the second year, the second payment may be taxed at a lower rate than if you received all $100,000 in one year.

Not all employers will agree to split severance, and some have policies against it. Ask your HR department whether splitting is possible before you accept the severance offer. If you negotiate a split, get the agreement in writing showing the payment dates.

Tax withholding on severance is not final

Your employer's withholding is an estimate of the tax you owe. When you file your tax return for the year, the IRS compares what was withheld to your actual tax liability based on all your income, deductions, and credits.

If too much was withheld, you receive a refund. If too little was withheld, you owe additional tax. This is especially common with severance because your employer withholds based on the assumption that you will work the full year, but you did not. You may have significantly lower income for the year than your employer assumed, which means you overpaid tax and will receive a refund.

To adjust withholding before you receive severance, you can file a new Form W-4 with your employer. Tell them you are leaving and ask them to adjust the withholding on your final paycheck and severance. However, most people do not do this and instead handle the adjustment when they file their tax return.

Vacation and paid time off paid as severance

When an employer pays out unused vacation days or paid time off as part of severance, that money is taxed as ordinary income just like the severance itself. Your employer withholds federal, Social Security, and Medicare taxes from it.

Unlike severance, you cannot roll unused vacation payouts into a retirement account. The IRS does not allow rollovers of vacation or PTO payments because they are considered wages for time already worked, not a lump-sum separation payment. You receive the after-tax amount and that is the end of it.

Some employers include vacation payouts in the severance package and some pay them separately. Ask your HR department how they will handle it so you know what to expect on your final paychecks.

State and local taxes on severance

In addition to federal tax, you may owe state income tax and local taxes on severance, depending on where you live and where you worked. Your employer withholds these taxes the same way they withhold federal tax.

If you moved to a different state after being laid off, you may owe tax to both your old state (where you worked) and your new state (where you now live). Some states have agreements to avoid double taxation, but not all do. Check your state's tax authority website or speak with a tax professional if you moved during the year you received severance.

Frequently Asked Questions

Can I avoid paying tax on severance by putting it in a savings account?

No. Severance is taxable income the moment you receive it or your employer directs it somewhere on your behalf. Putting it in a savings account does not change that. The only way to defer tax is to move it into a tax-deferred retirement account like an IRA or 401(k) through a direct or indirect rollover.

What if I do not have a retirement account yet?

You can open an IRA at any bank or brokerage before your severance is paid. A direct rollover can go into a brand-new IRA the same day you open it. If you do not have time to open an account before severance is paid, you can still do an indirect rollover within 60 days of receiving the check.

Do I have to roll over all of my severance, or can I roll over just part of it?

You can roll over as much or as little as you want. If your employer offers a direct rollover, you can tell them to send $50,000 to your IRA and pay you $50,000 as a check. With an indirect rollover, you receive the full check and decide how much to deposit into a retirement account within 60 days.

Will rolling over severance affect my unemployment benefits?

No. Unemployment benefits are based on your wages during a specific period before you filed, not on severance you receive after. Rolling severance into a retirement account does not change your unemployment status or benefit amount.

What if my employer made a mistake and did not withhold enough tax?

You will owe the difference when you file your tax return. The IRS will calculate what you owe based on your total income for the year. You can pay it with your return or set up a payment plan if you cannot pay in full. If you expect to owe a large amount, you can make an estimated tax payment before the important date to avoid penalties.