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How to Reduce Taxes On Severance Pay

You just got laid off. The good news is that your company gave you a higher severance package than you were expecting. Unfortunately, that also means your taxable income, and your tax burden, will be more than you were expecting, too.

Fortunately, there are ways you can manage your severance package to both lower your tax bill and to avoid a nasty surprise when you file your tax return. Let’s take a look at how you can lower your tax liability, first.

5 ways to lower your tax liability on your severance pay

When you enter into a severance agreement, your severance pay is considered ordinary income, and subject to ordinary income tax. So the name of the game is twofold:

  • Reduce the amount of taxable income you have in the current year by deferring it to future years
  • Spread out your income over as many years as possible

Let’s start with the options you might have for reducing your taxable income in the current year.

1. Maximize your retirement plans

It’s a good idea to take a look at your 401k, 403, or deferred compensation plans to see where you can maximize this year’s contributions. If you have enough money, it would be ideal to reach the contribution limits for the year.

Depending on where you are in the tax year at the time of termination, you may not be able to reach the contribution limit before your termination of employment. In that case, you might need to take a closer look at your retirement plan contribution options with your HR department.

Here are some things worth considering:

Roth vs traditional?

In this article, we’re focusing on deferring your taxable income, with the presumption that you’ll be in a higher tax bracket this year, then a lower tax bracket next year. But it’s still worth considering whether you’re in a lower tax bracket and would be better off maximizing your contributions to a Roth 401k instead (if your employer offers one).

Workplace vs. IRA

Should you max out your individual retirement account (IRA) as well as your workplace plans? It would probably make sense. However, if this is a higher income year for you, you might not be able to contribute directly to a Roth IRA, or take the tax deduction on a traditional IRA contribution.

In that case, you can still make a contribution to a nondeductible IRA. Depending on your circumstances, you may still be able to turn this into a backdoor Roth IRA conversion, but you need to pay attention to the tax laws in place, especially when it comes to the Roth conversion pro rata rule.

If cash flow isn’t an immediate concern, it might be worthwhile to max out all of your contributions.

2. Contribute to your health savings account

Your health savings account is a great way to sock away extra tax-free money for down the road. If your company offers a health savings account, and you’re currently in a high deductible health plan, you’ll want to maximize your HSA contribution. Although you can get temporary health insurance coverage through COBRA as a former employee, your health insurance will be much more expensive upon termination of employment.

And you might find that you may need every dollar that you just put into your HSA.

3. Put money away for college in a 529 account

Putting money into a college saving plan won’t reduce your current year federal income tax liability, Social Security tax, or Medicare tax. However, if you pay state income taxes, your 529 plan contribution may be tax deductible from your total income for the purpose of state taxes.

And even if your tax bill doesn’t change, you have that much growing tax deferred (or even tax free) for educational purposes.

4. Spread out your termination pay over several years

If you have the choice on receiving a lump sum payment from your former employer or having your severance payment spread out over several years, you should choose the latter.

Such payments will allow you to spread the total income out over multiple tax years, reducing the tax implications of your severance package in any one year.

5. Defer your capital gains

This really doesn’t fall under the category of reducing your tax bill so much as not increasing our gross income more than you have to.

If you’re working with a financial advisor, you may be looking at rebalancing your investment portfolio. While doing this, you need to make sure that any capital gains don’t drastically increase your gross income, and the amount of tax you’re going to pay.

If you have capital losses to harvest, it might be worth considering them. For tax purposes, you can offset $3,000 per year of ordinary income using capital losses. But if you’re looking at capital gains, you might ask your financial advisor to run a tax projection to see if you’re better off making those changes next year.

And that tax projection will come in handy as you try to figure out your tax situation this year.

How to avoid a huge bill at the end of the tax year

It’s not just enough for a taxpayer to pay their entire tax bill when they file their tax return after the end of the year. The federal government expects every taxpayer to pay an appropriate amount of taxes, based upon their taxable income.

One of the ways most people pay their taxes throughout the year is through income tax withholding. But an involuntary separation and the prospect of receiving severance pay might cause a change in your marginal tax rate and taxable income.

The best way to avoid owing the tax man a huge chunk of money, or even worse, finding out that you overpaid your taxes throughout the year, is to have your accountant or financial planner run a tax projection for you.

In normal years, a tax projection should help you understand whether your income tax withholding is adequate, or whether it needs adjustment. But when your financial situation changes, your tax projection becomes even more important.

And by running a tax projection into future years, you can actually see how much money you might save by:

  • Contributing to your tax-advantaged accounts, like an IRA or your 401k
  • Deferring your capital gains
  • Accelerating capital losses
  • Spreading out your severance benefits over multiple tax years

If your accountant doesn’t do tax projections, then find a financial planner who helps with tax planning.

Conclusion

Just because you’re facing involuntary separation from your employer doesn’t mean you have to pay through the nose for your severance package. With the right approach, the amount of money you can save through proper tax planning can be well worth the cost of hiring a financial planner to help you through this tricky financial situation.

If you liked this article, please check out our tax planning archives!