Is Severance Pay Taxable? What Gets Withheld, How Much You Actually Keep, and Ways to Reduce the Tax Hit

When a severance offer comes in at $50,000, the question most people ask immediately is how much of that they actually get to keep. The answer is less than the gross number and more complicated than a simple percentage. Severance pay is taxable income, but the way it is taxed and withheld depends on how the employer processes it and what your overall income picture looks like for the year. Understanding this before you negotiate your severance package can meaningfully affect your strategy.

Severance Is Ordinary Income

The IRS treats severance pay as ordinary income, subject to federal income tax at your marginal rate. There is no special lower tax rate for severance the way there is for long-term capital gains. Whatever tax bracket your total annual income puts you in, your severance pay is taxed at that rate.

In addition to federal income tax, severance pay is also subject to Social Security and Medicare taxes (FICA), state income tax in states that have one, and in some cases local income taxes. Social Security tax applies at 6.2 percent on wages up to the annual wage base, which is $168,600 in 2024. Medicare applies at 1.45 percent with no wage cap, plus an additional 0.9 percent on wages above $200,000 for single filers under the Affordable Care Act high-earner surcharge.

One exception worth knowing: courts have historically disagreed about whether severance payments paid to employees laid off through a reduction in force constitute FICA wages. The Supreme Court addressed this in United States v. Quality Stores in 2014 and held that severance paid to employees laid off in connection with a bankruptcy was indeed subject to FICA. The ruling is not universally settled for all severance scenarios, but employers default to withholding FICA on severance and the practical reality is that most severance is subject to all payroll taxes.

The Supplemental Rate Withholding Issue

How your employer withholds taxes from severance is separate from how you will ultimately be taxed. Employers typically process severance as supplemental wages, which triggers a flat federal withholding rate of 22 percent for amounts up to $1 million. If your severance is above $1 million, the excess is withheld at 37 percent.

The problem is that 22 percent withholding may be significantly less than your actual marginal tax rate. If you were earning $200,000 per year before being laid off, receiving a $150,000 lump sum severance in the same year will push your total income substantially higher and could push a significant portion of the severance into the 32 or 35 percent bracket. Withholding at 22 percent means you will owe additional taxes when you file your return.

Some employers instead aggregate severance with your regular wages and withhold at the normal income tax rate for your salary level. Under this method, withholding may be higher because it is applied to the combined regular pay plus severance amount for that pay period. Neither method guarantees that exactly the right amount is withheld for your specific tax situation.

Timing the Severance Payment

If you have any ability to influence when your severance is paid, the timing relative to the tax year can matter. Receiving a large severance in December versus January of the following year can shift substantial income into a different tax year. This matters most when your income varies significantly between years, such as when you expect to be unemployed for a significant period after the severance period ends.

Receiving severance in a year where your total income is lower means a lower effective tax rate on that income. A person who receives a $100,000 severance in a year where that is their only income will pay far less in taxes on it than someone who receives the same amount in a year where they also earned $150,000 from employment. If you are being offered a choice between lump sum and salary continuation, the timing implications of each deserve serious consideration.

Directing Severance to a Retirement Account

One of the most effective strategies for reducing the tax impact of severance is to contribute as much as possible to tax-advantaged retirement accounts. If you are still technically employed during a severance notice period or garden leave period, you may be able to increase your 401(k) contributions from your remaining paychecks before your last day. Contributions to a traditional 401(k) reduce your taxable income dollar for dollar.

After separation, if you have self-employment income or plan to consult during your transition, you may be eligible to contribute to a SEP-IRA or Solo 401(k) based on that income. A SEP-IRA allows contributions of up to 25 percent of net self-employment income. If you earn $40,000 in consulting income after receiving severance, a SEP-IRA contribution of up to $10,000 would reduce your taxable income by that amount.

If you are under 65 and have a High Deductible Health Plan, contributing to a Health Savings Account also reduces taxable income. The 2026 individual contribution limit for an HSA is $4,150 and the family limit is $8,300. HSA contributions are tax-deductible, grow tax-free, and are not taxed when used for qualified medical expenses.

Severance and Unemployment Benefits

Some states reduce or delay unemployment benefits when a person receives severance pay. New York, for example, treats severance received under a pay-in-lieu-of-notice agreement as wages and delays benefit eligibility accordingly. New Jersey similarly treats severance above a certain threshold as income that affects benefit eligibility.

Most states do not reduce unemployment benefits based on severance received as a lump sum after the termination date. The rules vary enough that checking your state's specific treatment before negotiating whether to receive severance as a lump sum or over time is worthwhile.

Non-Taxable Portions of a Separation Package

Not every element of a separation package is taxable. Continued health insurance coverage paid by the employer is generally not taxable to the employee. Employer contributions to a COBRA continuation premium are not taxed as wages, though there are limits on how this works with employer health reimbursement arrangements.

Reimbursements for actual business expenses incurred before the termination are not taxable. Outplacement services provided directly by the employer rather than as a cash payment are generally not taxable. Payments in settlement of legal claims may have different tax treatment depending on the nature of the claim, with physical injury and sickness claims potentially excluded from income under certain circumstances.

Use our severance pay calculator to estimate your gross severance based on tenure and industry, then work backward from the tax analysis here to understand what you are likely to net after withholding and after your annual return.