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What is Severance Pay?
Severance pay is the amount of compensation or benefits agreed upon between the employer and employee and given at the time of the employee’s termination of employment, often due to downsizing, layoffs, etc. Severance pay is not required under the FLSA and is a matter of agreement between the employer and the employee.
Severance pay also affects employees’ unemployment claims. If an employee is paid a lump sum severance, they can immediately apply for unemployment, but if they are paid severance over a few months, they cannot file for unemployment because they are still technically on the employer’s payroll.
Why Employers Offer Severance Pay
A severance package is solely based on mutual agreement between the employee and employer. Employers offer severance pay to help their employees transition smoothly to their next job and to cover the costs during the employee’s unemployment period.
If the termination is sudden, the employer can avoid a lawsuit from an angry employee if the employee is required to sign a legal release in exchange for severance.
Severance Pay Tax Methods
According to the IRS, severance pay is considered supplemental wages and is subject to social security and Medicare taxes, income tax withholding, and FUTA tax. The amount of severance is usually dependent on the length of employment.
Understanding how severance pay is taxed is essential to ensuring that taxes are not over- or under-withheld and that employers do not face any tax penalties. The implications of taxes also differ when you have a global workforce, such as considering local tax rates and deductions.
Severance pay is considered supplemental wages and, if paid in a lump sum, is taxable as wages for both income tax withholding and FICA. Employers can opt to use either of the two approved IRS methods, i.e., an optional flat rate withholding or an aggregate method. The details of these are below:
Flat Rate
According to the IRS, employers can choose to withhold supplemental wages at a flat tax rate of 22% only if the total supplemental wages do not exceed $1 million in a calendar year. If the total exceeds $1 million, the flat tax rate for withholding increases to 37% (or the highest income tax rate for the year).
Aggregate Method
In this method, an employee’s severance is added to their last regular paycheck, and taxes are calculated using regular payroll tax rates and income tax brackets. This method may result in larger withholding than usual.
Most employers choose the flat rate method as it is easier to calculate.
Payroll Taxes on Severance Pay
Severance pay is subjected to the below payroll taxes:
Both employees and employers contribute 6.2% each to the social security tax, for a total of 12.4%. The maximum base wage limit for 2024 was $168,600, and for the year 2025, it is $176,100.
Medicare
Both employees and employers contribute 1.45% each to Medicare taxes, for a total of 2.9% combined. Employees who earn more than $200,000 in a calendar year are subject to additional Medicare tax, but employers do not have to match the additional tax.
Deductions From Severance Pay
Deductions from severance pay depend on state wage deduction laws and the agreement between the employee and employer. Sometimes, employers uncover that the departing employee owes money to the company for advanced vacation time, credit card bills, unreturned equipment, etc.
Some severance agreements state that the owed items may not be deducted from severance pay, while others are silent about these deductions and base them on state laws.
