Navigating the Tax Implications of a Severance Package

When exiting an employer, one of the most frequently overlooked aspects is the taxation of the severance package. The specific amount of taxes taken out of a severance package can significantly impact your financial situation. It is important to understand the different methods of tax withholding and potential adjustments to ensure you pay the correct amount of tax.

Understanding the Different Methods of Tax Withholding

The amount of taxes withheld from a severance package depends on how the employer elects to categorize the payment. Employers typically choose between withholding taxes from severance payments as regular or supplemental wages. These distinctions can have a considerable impact on how much tax you owe.

Regular Wage Withholding

In the case of regular wage withholding, the severance package is treated as if you earn that amount every pay period. This approach can lead to significant over-withholding and may result in a substantial tax refund. Regular wage treatment includes withholding for:

Medicare and Social Security up to the applicable cap Additional Medicare tax for high earners

Supplemental Wage Withholding

With supplemental withholding, the employer will deduct the statutory federal and state taxes. The federal withholding rate for supplemental wages, up to $1 million, is 22%, and for amounts above that, it is 37%. California specifically withholds at a rate of 10.23%, with most individuals paying no more than 9.3%. These rates may be too high or too low, leading to potential over- or under-withholding.

State-Specific Tax Considerations

State tax withholding can vary significantly. For example, California withholds a 10.23% rate on supplemental wages, which is higher than the federal rate of 9.3%. It is crucial to understand your state’s specific tax rules to avoid any unexpected tax liabilities.

Adjusting Your Tax Withholding

To avoid receiving a large refund or owing additional taxes, it is wise to adjust your tax withholding at your next job. This process involves completing a new W-4 form and providing it to your next employer. By making the necessary adjustments, you can ensure that you neither overpay nor owe additional taxes come tax season.

Key Considerations for Avoiding Tax Penalties

When you receive a severance package, it is essential to consider the combined income from your recent job and the severance package. If you have income from two jobs, you may be at risk of under-withholding taxes, leading to potential tax penalties. To avoid these penalties, it is advisable to:

Review your current tax withholding to ensure it reflects your new income level. Consult a tax professional or CPA to ensure proper tax planning.

Conclusion

In conclusion, navigating the tax implications of a severance package can be complex, but understanding the different methods of tax withholding and making necessary adjustments can help you manage your financial situation effectively. Proper planning and review can help you avoid penalties and ensure you pay the correct amount in taxes.