Taxes are one of the last things you want to think about when you leave a job. However, United States tax law at the state and federal level holds that you must pay taxes on any compensation you receive conditional upon your leaving a job. Some exemptions apply to severance pay at state level, though the Internal Revenue Service taxes all severance pay indiscriminately.
The federal government taxes severance pay as a form of standard income. According to IRS Publication 17, Your Federal Income Tax, all money you earn during the course of a year, such as salary, tips, fringe benefits, unemployment pay and severance pay, qualifies as forms of personal income. When filing taxes in a year in which you receive severance pay, you must report this pay as income and pay taxes on it. If your employer taxes your severance pay before giving it to you, you may not end up paying additional taxes on it.
As with the federal government, state governments consider severance pay a form of personal income and tax it accordingly. The percentage of taxes levied against your severance pay at the state and federal levels depends upon your tax bracket, which depends in turn upon your total annual income. As with any other form of income, you pay taxes on severance pay at the state, federal and municipal levels in the same tax year unless you qualify for one of two available state exemptions.
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Two exemptions apply to state taxation on severance pay. Alabama exempts the first $25,000 of severance pay from taxation. For instance, if your company pays you a $45,000 severance package and you live in Alabama, you only pay taxes on $20,000 of that amount. North Carolina exempts the first $35,000 of severance pay though only if you leave a job involuntarily. If you agree to leave in exchange for a severance package, you must pay taxes on all of it.
Negotiating Severance Pay
Depending on how you receive a severance package, you may end up moving into a higher tax bracket. For instance, if your company offers you a lump sum severance package in addition to any salary you earned during the course of the year, the combined income may constitute enough to bump you into a higher tax bracket. In order to avoid this, and thus avoid paying a higher tax rate on our income, Bloomberg's Businessweek recommends negotiating a severance package spread over multiple tax periods.