Severance pay is an unemployment compensation paid by the employer in addition to any employment compensation offered by federal and state unemployment programs. Although they are generally included together, severance pay does not include vacation pay, sick leave or final wages. Some business use this severance pay as a sweetener to encourage laid-off workers to sign a release of all claims, which is a document that guarantees the ex-employee will not sue the employer in the future.
Severance pay is considered taxable income by the Internal Revenue Service. Californian taxpayers who lose their job must pay taxes on their severance packages during the tax year they receive it. Your employer should withhold taxes on your severance pay and include the amount in your W-2 tax form. The federal tax on severance income depends on the amount and the circumstances of the taxpayer. However, the standard deduction for federal taxes on severance pay is 25 percent. For example, if you receive $1,000 in severance pay, your employer may withhold $250 toward federal income tax.
California State Tax
California does not require unemployed workers to pay taxes on their unemployment benefits. However, as far as taxes go, California considers severance as part of your wage and not as unemployment compensation. The standard deduction on severance pay for California state taxes is 6 percent. Again, your employer should withhold this amount from your net severance pay and detail it in your W-2 Form. However, if your employer does not withhold the taxes--federal or state--on your severance package, you might have to make estimated payments yourself.
Medicare and Social Security
Although severance pay is subject to income tax, it is not always subject to Medicare and Social Insurance taxes. According to a 2002 Court of Federal Claims decision, the severance pay of employees who are laid off involuntarily is considered supplemental unemployment compensation and is not subject to Medicare and Social Security taxes. However, if the employer received severance pay as a bonus in exchange for voluntarily terminating their employment, it might be considered part of their wage and therefore, subject to Medicare and Social Security Tax.