Severance pay comes into play when an employee must part ways with a company, whether due to layoffs, restructuring, or retrenchment. And this makes understanding severance pay and related taxes critical.
Taxation is complex, yes, but severance pay taxation takes it a notch higher, influenced by federal, state, and even local tax regulations.
So, severance pay — is it taxable? What are the regulations around withholding and deductions? More importantly, how can you, as an employer, be able to process severance pay tax to avoid possible compliance risk yet bring clarity and reasonability to your employees?
This article explores the ins and outs of severance package tax, from severance pay tax rates to payroll deductions, and outlines why tools like Multiplier’s global payroll solution can make these processes more efficient. We’ll use the USA as a case study throughout.
Why understanding severance pay taxation is important
Severance pay is generally treated as additional income, meaning it’s subject to both income and payroll taxes- but not always in the same way as regular wages. Getting these details right is critical to avoiding compliance issues and ensuring employees don’t face surprises during tax season.
Mistakes can lead to under- or over-withholding, exposing your company to penalties or leaving former employees with unexpected tax bills. In more serious cases, poor handling can even trigger audits from tax authorities.
Take John, an employee in New York City, who receives a $50,000 severance package after a layoff. With federal, state, and local taxes in play, his total withholding is significantly higher than it would be in a low-tax state. Without accurate calculations, he could end up owing more at tax time- creating stress for both him and his employer.
For global teams, the complexity increases further. Severance may be paid across multiple countries and currencies, each with its own tax rates, thresholds, and local rules.
The risk isn’t theoretical either. Multiplier’s Global hiring gap report shows that only 8% of companies are fully compliant with international tax and labor laws- leaving 92% exposed to exactly these kinds of audit risks and penalties.
This is where a global payroll platform like Multiplier becomes invaluable, helping you calculate, manage, and process payments accurately across 100+ currencies while staying compliant.
Severance package tax rate and withholding
When managing severance pay tax rates, you need to understand the local laws in great detail. For example, in the USA, this means considering the federal laws and the respective state laws, and any other local obligations to avoid under- or over-withholding. Follow these points.
1. Federal tax rates on severance pay
The Internal Revenue Service (IRS) considers severance pay an additional income, similar to bonuses or commissions. The federal income tax on severance pay can be calculated by incorporating either of the two alternatives:
- Flat rate method: As of 2025, the IRS requires employers to withhold 22% of the severance payment as a flat rate, which is applicable to all additional wages up to $1 million in a calendar year.
- Aggregate method: This method groups the severance pay with the employee’s last paycheck and calculates the usual payroll tax on severance pay using the regular income tax brackets. In this situation, it might raise the employees’ taxation proportions to much higher levels, resulting in them withholding more money than they did previously.
Most companies tend to use the flat rate method because it makes the calculation easy and fast, ensuring consistency in payments and with fewer potential complications.
Nonetheless, it is necessary to emphasize that the severance pay tax rates at the federal level may be regarded differently with severance pay at the state or local levels. These rates may change from region to region.
2. State and local taxes on severance pay
State and local tax laws add another layer of complexity to severance pay in global payroll. Every state can set its own income tax on severance pay. For instance, as of 2025:
- California: Severance pay is subject to the state’s progressive income tax rates, which range from 1% to 12.3%. Additionally, individuals earning over $1 million in total income are subject to an extra 1% Mental Health Services Tax, bringing the top marginal rate to 13.3%. This means the higher the severance, the more tax is withheld.
- New York: Both New York State and New York City impose taxes on severance pay. The state’s income tax rate goes up to 10.9%, and New York City adds a local tax of up to 3.876%. As a result, employees residing in the city may face significantly higher total withholding compared to those living outside the city.
- In contrast, states like Florida and Texas, which don’t have a state income tax, make it simpler for employers, as no state taxes are withheld from severance payments.
Let’s understand this better through an example: imagine an employee in California receiving a severance of $100,000. In addition to the 22% federal withholding, California’s state tax rate could be up to 12.3%, depending on the employee’s total income. This means an additional $12,300 might be withheld for state taxes, significantly reducing the net amount the employee takes home.
In comparison, an employee in Texas receiving the same $100,000 severance would only have federal taxes withheld, as Texas does not have a state income tax. In this case, the employee’s net severance would be significantly higher.
3. Employer withholding responsibilities
The tax procedures that relate to your employee’s severance payment rest solely on your shoulders. But tools like Multiplier’s global payroll software can make this easier by automatically calculating and withholding the right amount of tax for severance pay, regardless of where your employees are located.
Taking advantage of these automated tools is crucial because manual tax management is a widespread struggle. As per Multiplier’s Global hiring gap report, 53% of companies cite international tax compliance as a top payroll challenge
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Severance pay deductions and payroll taxes
Given below are some of the key severance pay deductions and payroll taxes. Let’s have a closer look.
1. Payroll taxes on severance pay
Along with regular income tax, severance pay is also subject to certain other taxes, such as payroll tax. In the USA, this includes:
- Social Security taxes: In 2025, the Social Security tax is 6.2% for both the employer and the employee but limited to a maximum wage of $168,600. Severance payments are counted toward this cap, so if the employee’s severance pushes them over the limit, Social Security taxes will no longer apply.
- Medicare taxes: Medicare taxes apply to all wages, including severance pay, at a rate of 1.45% for both employers and employees. Further, an extra tax of 0.9% would be paid by employees whose compensation exceeds $200,000 as a Medicare surtax.
These taxes can significantly reduce the amount of take-home severance, which is also the reason both employers and employees should be aware of their effects on the final pay.
2. Common deductions from severance pay
In addition to payroll taxes, certain other deductions can also be imposed on severance payments. Depending on your company policies and the agreement with the employee, you may need to deduct retirement contributions and health insurance premiums.
- Retirement contributions: A few severance packages generally permit employees to make retirement contributions such as 401(k) or pension plan contributions even after discontinuing employment. These deductions are typically pre-tax, hence lowering taxable income.
- Health insurance premiums: If, for example, you receive a severance and continue with health benefits under COBRA, then health insurance premiums may also be subject to such deductions.
It is highly important to inform your employees about these deductions clearly so that they are knowledgeable of the net pay after paying tax and other deductions.
Common misconceptions about severance pay taxes
Misconception 1: Severance pay is free from tax
Some employees may think of severance pay as an untaxable unit on their paystub. However, severance benefits are usually not free from taxation.
Misconception 2: You can always spread severance over multiple years
While some employees may prefer to spread out severance payments over time to reduce tax burden, severance is usually issued as a one-time payout. In fact, some states in the U.S. have strict regulations for termination and severance.
Case study: Cross-border severance pay taxation
This cross-border case study provides an in-depth examination of the complexities of severance package taxation.
Case study: Cross-border severance pay taxation
This cross-border case study provides an in-depth examination of the complexities of severance package taxation.
Scenario:
A company registered in the United States terminates an employee based in Germany. Under the severance agreement, she would receive a lump sum severance equivalent to three months’ salary.
Tax implications in the U.S.:
The severance payment would be considered additional income and would attract a flat 22% withholding rate for federal tax, along with any applicable state taxes (depending on the state). Social Security and Medicare taxes would also be applicable, subject to wage limits.
Tax implications in Germany:
Severance payments are taxable in Germany because they form part of the employee’s wages; however, they may qualify for tax relief under the income tax’s fifth rule (Fünftelregelung). As of January 1, 2025, this relief is no longer applied by the employer at the time of payroll processing. Instead, the employee must claim the relief when filing their annual income tax return. Additionally, in Germany, severance pay is exempt from payroll taxes, meaning no Social Security contributions are levied on severance payments.
Using a good payroll software solution, the organization will be able to accurately determine tax withholdings based on the respective employees’ locations and comply with both U.S. and German tax requirements.
See what the Reddit community on r/WorldWithoutLimits thinks about severance pay in other countries like Singapore.
FAQs
How is severance pay taxed differently from regular wages?
Severance pays are regarded as additional or secondary incomes and have tax withholding that is different from normal salaries. For federal tax withholding, a good proportion of the salary, i.e., a 22% flat rate, is typical although the rate changes if the aggregate method is applied.
What should I do if I think too much tax was withheld from my severance?
Employees can claim a refund for over-withheld taxes when filing their annual tax returns. If your employees raise concerns about withholding, make sure they consult with a tax professional.
Can I spread severance pay over several years to reduce my tax burden?
Severance payments can be spread over several years to lessen the proportion to be paid in taxes but it is most often paid as a lump sum. Nevertheless, tax consultants may suggest other ways in which employees can protect themselves from the adverse effects of large payouts.
Are there any tax exemptions or special rules for severance pay?
In exceptional instances, it may be possible to obtain severance payment exemption, when they are part of a lawsuit settlement. However, it is recommended to always verify with a tax advisor if there are any chances for exemption.
