How can I minimize or avoid taxes on severance pay?

You generally cannot completely avoid taxes on severance pay, because the IRS treats severance as regular wages.

However, you can legally reduce or manage the tax impact by timing the payments, using pre-tax contributions, and offsetting the income with deductions or losses.

1. Why Severance Pay Is Taxable

The IRS considers severance pay to be compensation for services.

That means severance is:

• Subject to federal income tax
• Subject to Social Security and Medicare (FICA) taxes
• Usually subject to state income tax
• Not treated as unemployment compensation

2. Spread Severance Payments Over Two Tax Years (If Allowed)

If your employer agrees to pay severance in installments, you may be able to:

• Receive part of the severance in one tax year
• Receive the remainder in the next tax year

This can:

• Keep you in a lower tax bracket
• Reduce phase-outs of credits and deductions

Example

• $60,000 severance paid all at once in 2025 → higher tax bracket
• $30,000 paid in Dec 2025 + $30,000 paid in Jan 2026 → possibly lower total tax

This only works if the money is actually paid in different calendar years.

3. Maximize Pre-Tax Retirement Contributions

If severance is paid through payroll, you may be able to reduce taxable income by increasing pre-tax contributions.

Options

• 401(k) / 403(b) contributions
• Traditional IRA contributions (if eligible)

What this does

• Lowers federal and state income tax
• Does not eliminate Social Security and Medicare tax

4. Use an HSA or FSA (If Eligible)

If you qualify during the year severance is paid:

Health Savings Account (HSA)

• Requires coverage under a high-deductible health plan
• Contributions are pre-tax
• Reduces taxable income

Flexible Spending Account (FSA)

• Available only while still employed
• Pre-tax contributions reduce income

5. Offset Severance With Deductions or Losses

You may reduce the tax impact by offsetting severance income with:

Common offsets

• Capital losses (up to $3,000 against ordinary income)
• Itemized deductions, such as:
  
  • Medical expenses exceeding 7.5% of AGI
  • Charitable contributions
• Business losses (if applicable)

6. Understand Withholding vs. Actual Tax (Very Important)

Severance is often withheld at a flat 22% federal rate (supplemental wage rules).

This is not your final tax rate.

• You may get a refund if too much was withheld
• Or owe more if your marginal rate is higher

You can adjust withholding by filing a new Form W-4, but this only affects cash flow, not total tax owed.

7. What You Cannot Do

• You cannot roll severance into an IRA tax-free
• You cannot avoid Social Security and Medicare taxes
• You cannot treat severance as unemployment benefits
• You cannot exclude severance because you were laid off

Related Questions

• When I receive rmd from the IRS, how can i calculate the amount which was non deductible traditional IRA?
• Are required minimum distributions rmds taxed in California?

Sources:

IRS Publication 525, Taxable and Nontaxable Income

Internal Revenue Code §61(a)(1) – Gross income includes wages

IRC §451 – Income is taxable when received

IRC §401(k)

IRS Publication 560, Retirement Plans

IRS Publication 590-A (IRAs)

IRC §223 (HSA rules)

IRS Publication 969

IRC §1211(b) – Capital loss limit

IRS Publication 550

IRS Topic 761 – Supplemental Wages

IRS Topic 418 – Unemployment vs wages