If you have recently lost your job and are offered a severance pay agreement, you may be wondering how much of the agreed-upon amount you will actually see after taxes. This is a very good question, and one that even the U.S. Supreme Court has not yet figured out.
There are a number of factors that determine how much your severance pay can be taxed. The first factor is how your severance pay is defined; the second is how your severance pay is paid out.
There is much debate over how severance pay is categorized when it comes to the IRS. If severance pay is considered wages for services rendered, it is subject to FICA tax laws and will be taxed at a higher payroll rate. However, since severance pay is given upon termination, many are arguing that severance cannot be considered wages, and therefore should be taxed at a lower rate.
The U.S. Supreme Court is currently set to hear one such case this month, which could set a precedent for how all severance pay is categorized. Currently, while this is being decided, the typical practice is that severance pay is taxed at the higher FICA rate, but requests for refunds for over-payment can be made after the fact.
The other determining factor on how much of your severance pay is taxed depends on the schedule of how your pay is distributed to you. If you receive your pay in smaller amounts over time, it will be taxed at a lower rate than if you receive one large, lump sum. The IRS taxes single lump severance payments as “bonuses,” which means they are taxed at a much higher rate than normal wages.
The end result is that yes, your severance pay is subject to tax. But the question of how much tax you will owe depends upon your circumstances and now, upon the Supreme Court as well.
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