Losing a job hurts, but severance pay can make it a little less painful. Severance can, however, bring a pain of its own. As far as the Internal Revenue Service is concerned, severance is taxable pay just like your regular salary. If it's a huge severance, there's a chance it will push your income numbers for the year into a new tax bracket.
Severance Pay Rules
Severance pay typically works out to one week of pay for every year of work, though employers often impose a floor and a ceiling on the total. Your employer can offer it as part of a formal benefit plan, or give it out voluntarily when she deems it fit. While your employer has to honor any written plan, severance pay is a courtesy, a way to say thank you for the years you put in at the company. There's no legal rule anywhere to say he has to give it to you even if he's given it to others.
Suppose you file a joint return and report an income of $70,000 for the year. As of 2013, that puts you into the 15 percent tax bracket. If you get another $4,000 in severance pay, that puts you over the cut-off point for the next bracket -- $72,500. The top $1,500 of your income for the year gets taxed at 25 percent. The total of what you get in that last paycheck shows up along with your regular wages and salary on your W-2.
Your severance package may include non-cash benefits such as continued medical insurance, stock options or extra 401(k) contributions. Yes, some of these extras may be taxable. 401(k) contributions are not, though, and neither is medical insurance. Stock options may be taxable when you get them or exercise them. It depends on the details of the option grant. If you get placement assistance in a new job hunt, you may have to pay tax on that too.
If you have taxable pay in your severance package, expect your employer to take out withholding. Even if you need all the money you can get to tide you over to your next job, that withholding is just as mandatory as when you still had a job. Your employer has to take out for federal and state income taxes, as well as Social Security and Medicare.