Taxes 2023: How Does Severance Pay Get Taxed?

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Part of the reason investors fled the stock market in 2022 was over fears of a potential recession in 2023. With inflation reaching multi-decade highs and the Fed aggressively raising interest rates, many economists feel that at least some type of recession is likely.

In response to this potential downswing — and perhaps reflecting slowing business conditions they were already experiencing — many companies already began laying off some of their workers in 2022. Typically, corporate layoffs come with severance packages, softening the blow for ex-employees and giving them time to find new employment.

If you were one of the unfortunate ones to lose your job in 2022, you should be aware that there may be tax consequences when you file your 2023 return. Here are the most important things to know.

Is Severance Pay Taxable?

One of the unfortunate realities about severance pay is that it is fully taxable. In the eyes of the IRS, severance pay is the same as your ordinary wages or salary.

Employers typically describe severance pay as the continuation of salary or wages in exchange for accepting employment termination. Essentially, your employer is offering to continue to pay you for a matter of weeks or months in exchange for getting your long-term salary off the books.

So, even though you don’t physically have to report to work, your severance pay effectively continues your salary for a predetermined time.

What About Sick Pay or Payment for Vacation Days? 

Most any pay that you receive upon your termination is considered taxable income. This applies to any sick pay or accrued paid time off that your employer includes in your payment.

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Any unemployment compensation you may receive from federal or state governments is also considered taxable income.

What Types of Taxes Do I Have To Pay?

Generally speaking, you should consider your severance pay to simply be a continuation of your regular paycheck. This means you’ll pay the same taxes on your severance pay that you pay on your ordinary income.

Federal income tax is the most obvious tax obligation, along with state income tax if you live in a state that has them. You’ll also pay Social Security taxes on your severance pay, unless you earn more than the wage limit in any given year ($147,000 for 2022).

Is There a Way To Reduce Taxation of Severance Pay?

There’s no way to avoid taxation of your severance pay unless you put it in a tax-advantaged account, just like you can’t avoid taxes on your ordinary income unless you do the same. For example, if you take $6,000 of your severance pay and put it into an HSA or IRA, you can deduct that amount from your taxes. Beyond that, it’s not really possible to avoid taxation of your severance pay.

However, there is one scenario in which you might be able to lower the taxes you owe. If you can convince your employer to spread your severance payout across two or more years, you’ll only have to declare that income in the years you receive it. If you earn less outside money in one of those years, you may fall into a lower tax bracket and therefore owe less in taxes on your earnings.

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