Severance pay is taxable income, but you have options to reduce what you owe

Severance is treated as wages by the IRS, which means federal income tax, Social Security tax, and Medicare tax all apply. Your employer will withhold taxes from the payment unless you negotiate otherwise — but negotiation is possible, and so is tax planning before you receive the money. The amount you actually owe depends on how the severance is structured, whether you roll it into a retirement account, and what other income you have that year.

You cannot avoid the tax entirely, but you can reduce it. The most common strategies are spreading the payment across two tax years, rolling part of it into an IRA or 401(k), and timing the receipt to land in a lower-income year. Each approach has rules and deadlines, and some require your employer's cooperation before the check is cut.

Key Takeaways

  • Your employer withholds federal, Social Security, and Medicare taxes from severance unless you ask them not to — but nonwithholding means you owe the full amount when you file.
  • If your severance includes unused vacation or sick time, that portion is always taxable as regular wages with no special treatment.
  • You can roll up to $35,000 of severance into a new or existing IRA under the Saver's Credit rules if you meet income limits, deferring tax on that portion.
  • Spreading severance across two calendar years (by asking your employer to pay part in December and part in January) can lower your tax bracket and reduce total tax owed.
  • Outplacement services, retraining, and job search assistance paid by your employer may not be taxable if they meet IRS rules — ask your employer what portion qualifies.

How your employer withholds tax on severance

When you receive severance, your employer treats it as supplemental wages. Federal withholding is usually 22 percent for amounts under $1 million, or 37 percent for amounts over $1 million. Social Security tax (6.2 percent) and Medicare tax (1.45 percent) are also withheld, plus any state and local income tax your state requires. The total can be 30 to 40 percent of the gross amount.

Your employer is required to withhold unless you sign a form requesting no withholding. That form is not a tax exemption — it means you will owe the full tax bill when you file your return. Do not sign it unless you have already set aside the money to pay the IRS. If you do sign it, you may owe estimated tax payments to avoid penalties.

Ask your employer's payroll department for a breakdown of what will be withheld before the payment is made. This gives you time to decide whether to request different withholding or to plan for the tax bill.

Rolling severance into a retirement account

If you have access to a traditional IRA or a 401(k), you may be able to roll part of your severance into it and defer tax on that portion. The rules are strict and depend on the type of account and your income.

A traditional IRA accepts rollovers from severance if you are not covered by an employer retirement plan. If you are covered by a plan at work, income limits apply: for 2024, you can deduct IRA contributions only if your modified adjusted gross income is below $77,000 (single) or $123,000 (married filing jointly). Severance counts as income, so rolling it in may push you over the limit and reduce the deduction. Ask a tax professional whether a rollover makes sense for your situation.

A 401(k) can accept a rollover of severance if your employer's plan allows it. Not all plans do. Contact your plan administrator to ask whether in-service rollovers are permitted. If they are, you can roll the severance into the 401(k) and defer tax on that amount until you withdraw it in retirement.

You have 60 days from the date you receive the severance to complete a rollover. If you miss the deadline, the full amount is taxable in the year you received it.

Spreading severance across two tax years

If your employer will agree to pay part of your severance in December and part in January, you can split the income across two tax years. This can lower your tax bracket in each year and reduce your total tax bill.

Example: If you would receive $100,000 in severance in December, your 2024 income might push you into the 24 percent federal bracket. If your employer pays $50,000 in December 2024 and $50,000 in January 2025, your 2024 income is lower, and you may stay in the 22 percent bracket. Your 2025 income is also lower than it would have been if you received the full amount in one year. The tax savings depend on your other income and your filing status.

Ask your employer in writing whether they will split the payment. Some will; others have a policy against it. There is no legal requirement for them to agree, but it costs them nothing, so it is worth asking. Get the agreement in writing before the payment is made.

Outplacement services and retraining programs

Some severance packages include outplacement services (job coaching, resume writing, interview prep), retraining programs, or tuition assistance. These are not always taxable. The IRS allows employers to pay for certain educational and job search services without those payments counting as taxable wages to you.

The rules are narrow. The service must be for job search assistance or retraining for a new field, not general education. It must be paid directly to the provider, not to you as cash. And your employer must have a written policy stating that the benefit is available to all employees in similar circumstances, not just to you.

Ask your employer's HR department which portion of your severance package qualifies as nontaxable outplacement or retraining. Get the answer in writing. If your employer does not have a written policy, the payments are likely taxable.

Unused vacation and sick time in severance

If your severance includes payment for unused vacation days or sick time, that portion is always taxable as regular wages. There is no special treatment or exclusion. Your employer will withhold tax on it just as they would on regular pay.

Some states require employers to pay out unused vacation; others do not. Some employers pay it as part of severance; others do not. Check your employment contract and your state's labor laws to see what you are may have access to to. The amount owed does not change the tax treatment — it is taxable either way.

What to do if you owe more tax than was withheld

If your employer withheld less tax than you actually owe, you will owe the difference when you file your return. This happens when severance pushes you into a higher tax bracket or when you have other income that year.

You can pay the balance when you file. If the amount is large, you may want to make an estimated tax payment before the filing deadline to avoid penalties. Estimated tax payments are due on April 15, June 17, September 16, and January 15 of the following year.

If you expect to owe a large amount, talk to a tax professional before the end of the year. They can help you decide whether to make an estimated payment and can review your withholding strategy for the rest of the year.

Frequently Asked Questions

Can I negotiate with my employer to withhold less tax?

Yes, you can ask your employer to withhold a different amount or no amount at all. But nonwithholding does not reduce your tax bill — it just moves the payment from your employer to you. You will owe the full tax when you file. Only a rollover into a retirement account or spreading the payment across two years actually reduces tax owed.

Is severance taxed differently if I was laid off versus if I quit?

No. The tax treatment is the same regardless of the reason for separation. Severance is taxable wages in both cases. The only exception is if your employer offers a true separation agreement that includes a payment for releasing legal claims — even then, the payment is taxable, though some portions may may have access to for different treatment.

What if I receive severance and then start a new job in the same year?

Your total income for the year includes both the severance and the new job income. This can push you into a higher tax bracket. If you knew this would happen, you could have asked your employer to split the severance across two years. If it is too late, a tax professional can help you understand your liability and whether you need to make an estimated payment.

Do I have to report severance on my tax return?

Yes. Your employer will send you a W-2 form that includes the severance as wages. You report the W-2 income on your return. If you received severance and did not receive a W-2, contact your employer — they are required to issue one.

Can I deduct job search expenses from my severance tax?

No. Job search expenses are not deductible on your personal tax return. However, if your employer paid for job search services as part of your severance package, and those services meet IRS rules, they may not be taxable to you in the first place. That is different from deducting an expense you paid yourself.