Severance pay is taxed as ordinary income, but the way your employer withholds taxes can create a larger bill than you expect

Severance is not a special category for tax purposes. The IRS treats it as wages, which means federal income tax, Social Security tax, and Medicare tax all explore — the same as your regular paycheck. What makes severance different is how much tax gets withheld at the time you receive it. Your employer may withhold taxes using a method that assumes you will earn that amount every pay period for the rest of the year, which can result in over-withholding. You may also owe state income tax on severance, depending on where you live and where you worked.

The tax you actually owe depends on your total income for the year, not just the severance amount. If severance is your only income that year, you may get a refund when you file. If you have other income — from a new job, investments, or a spouse's wages — your severance could push you into a higher tax bracket, meaning you owe more than what was withheld.

Key Takeaways

  • Severance is taxed as ordinary wages, subject to federal income tax, Social Security tax (6.2 percent), and Medicare tax (1.45 percent).
  • Your employer may withhold too much tax on severance because they calculate withholding as if you will earn that amount every pay period for the full year.
  • The actual tax you owe depends on your total income for the year, so you may get a refund or owe more when you file your return.
  • State income tax on severance varies by state and by whether you worked in a state different from where you live.

Federal income tax withholding on severance

Your employer withholds federal income tax based on the W-4 form you completed. When severance is paid in a lump sum, the payroll system often treats it as a single paycheck and calculates withholding using the aggregate method or the percentage method, depending on your employer's payroll software.

Under the aggregate method, your employer adds the severance to your regular paycheck for that pay period, calculates tax on the combined amount, and then subtracts the tax already withheld from your regular pay. This can cause significant over-withholding if the combined amount is large. Under the percentage method, your employer applies a flat withholding rate (often 22 percent for federal income tax on supplemental wages like severance) if the severance is paid separately from your regular paycheck. Neither method accounts for your actual tax situation for the year.

You can reduce over-withholding by filing a new W-4 with your employer before you leave, but this only affects future paychecks. Once severance is paid, the withholding is locked in. You will reconcile the actual amount owed when you file your tax return.

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. In 2024, the Social Security wage base is $168,600, meaning you pay Social Security tax on severance only up to that limit for the year. If you have already earned $168,600 in wages before receiving severance, no additional Social Security tax is withheld on the severance itself.

Medicare tax has no wage base limit, so 1.45 percent is withheld on all severance, regardless of how much you have already earned. If your total income for the year exceeds $200,000 (or $250,000 if married filing jointly), you also owe an additional 0.9 percent Medicare tax on the excess, which may explore to your severance.

FICA taxes are withheld automatically by your employer and are not refundable, even if you do not owe income tax for the year.

State income tax on severance

Most states that have an income tax will tax severance as ordinary income. The rate and withholding method depend on your state of residence and the state where you worked. If you worked in one state and live in another, you may owe tax to both, though most states offer a credit to avoid double taxation.

Some states have no income tax (Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming), so if you live in one of these states, you will not owe state income tax on severance. If you worked in a state with income tax but now live in a state without one, your former employer may still withhold state tax unless you provide a form stating your new residency.

A few states treat severance differently under specific circumstances. For example, some states may not tax severance if it is paid as part of a reduction in force or plant closure, but this varies widely. Check your state's tax authority website or speak with a tax professional if you worked across state lines.

How to estimate what you will owe

Start by adding up all income you expect for the year: severance, wages from any other job, investment income, and income from your spouse if you file jointly. Then subtract the standard deduction for your filing status (in 2024, $14,600 for single filers and $29,200 for married filing jointly). The result is your taxable income.

Use the IRS tax tables or a tax calculator to find the federal income tax on that amount. Then add FICA taxes: 6.2 percent Social Security tax up to the wage base, and 1.45 percent Medicare tax on all wages. Add state income tax based on your state's rates. Compare this total to the amount your employer already withheld from your severance and your other paychecks. If you withheld more, you will get a refund. If you withheld less, you will owe when you file.

This is an estimate only. Your actual tax depends on deductions, credits, and other income you may not have accounted for. A tax professional can give you a more precise figure.

What happens if too much tax was withheld

If your employer over-withheld, you will receive the excess as a refund when you file your tax return. This is common when severance is your only income for part of the year, or when you leave a job partway through the year and do not earn enough to use up the standard deduction.

You cannot get the refund until you file your return, which is typically due April 15 of the following year. If you need the money sooner, you can file early once you have all the documents from your employer (your final W-2 and any other income statements).

What happens if too little tax was withheld

If your employer under-withheld, you will owe the difference when you file your return. You may also owe estimated tax penalties if you did not pay enough tax throughout the year. The IRS charges interest on unpaid taxes, calculated daily from the due date until you pay.

To avoid penalties, you can pay the balance in full by the tax return due date, or set up a payment plan with the IRS. If you expect to owe, you can also make a voluntary payment before filing to reduce the interest owed.

Frequently Asked Questions

Can I avoid taxes on severance by putting it in a retirement account?

No. Severance is taxable income in the year you receive it, regardless of what you do with the money afterward. You can contribute to a retirement account (like an IRA or 401(k)) using severance money, but the contribution does not reduce the tax on the severance itself. The contribution may reduce your taxable income if you meet other requirements, but that is a separate calculation.

Is severance taxed differently if I sign a release agreement?

No. The tax treatment of severance does not change based on whether you sign a release or non-compete agreement. The IRS taxes severance as wages regardless of the conditions attached to it. However, if the severance includes payment for something other than wages — such as a non-compete clause or confidentiality agreement — that portion may be taxed differently. Consult a tax professional if your severance agreement specifies payments for non-wage items.

Do I have to pay taxes on severance if I am laid off due to a plant closure?

Yes. Severance is taxable income regardless of the reason for your separation. Some states offer tax breaks for workers affected by mass layoffs or plant closures, but these are rare and vary by state. Check your state's tax authority to see if you may have access to for any special treatment.

What if my severance is paid over time instead of as a lump sum?

Severance paid over time (such as monthly payments for six months) is still taxable income in each year you receive it. Your employer will withhold taxes on each payment using the same rules as regular wages. The total tax you owe may be lower than if you received it all at once, because the payments are spread across multiple pay periods and may not push you into a higher tax bracket.

Can I deduct severance as a business loss on my taxes?

No. Severance is taxable income, not a deductible loss. You cannot reduce your taxable income by the amount of severance you received. However, if you are self-employed and received severance from a business you owned, different rules may explore — speak with a tax professional about your specific situation.