Why are taxes on severance so high?

You just got fired and the tax man took half your severance. How is that fair?

Have you ever noticed how big checks get gouged on taxes? It sucks bad enough with bonuses and commission checks. When it’s your severance, it hits like a kick in the crotch.

But why? Who came up with this 💩y system?

I'm so glad you asked!

There is something that payroll administrators can do to mitigate the Big Check Suckerpunch. It’s not shady and doesn’t expose the departing employee to risk.

Here’s how it works:

Payroll software basically calculates taxes like this: "If this person made this much every [period covered by the check], how much would they make over the full year?" 

Then they deduct at that tax rate.

Result: If your severance is calculated based on a standard pay cycle (or less), a big lump-sum payment like severance will bump you up to a higher tax bracket. 

Translation: You get taxed like you’re made of money.

In some cases, using the default tax settings for severance could lead to up to 50% of the check going to state and federal taxes. If 401(k) contributions, insurance premiums, and other deductions come out of that check, it dwindles even more. 

You’ll get the overpayment back when you file your return next year, but that’s no comfort to anyone heading into unemployment. If you just got laid off, you need that money NOW.

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Here’s how your payroll admin fixes it:

When you’re processing severance or other lump sum payments, use the ‘supplemental wages’ setting. Depending on your payroll provider, you may need to run an off-cycle payroll to find it.

Supplemental wages locks the federal tax rate at 22%, which will be more favorable for any lump sum payment greater than about $4,000.

But the ‘supplemental wages’ setting isn’t enough. The state may still tax it like Richie Rich. That’s where the off cycle 'pay period' setting comes in.

Make sure that you adjust the pay period dates to cover the actual period of time the payment covers. For example:

➡️ Quarterly bonuses - the pay period should cover 3 months

➡️ Annual bonuses - the pay period should cover the full year

➡️ Retro pay - the pay period should cover the date the raise was effective until the date their regular pay was updated

➡️ Severance - can be adjusted to cover the hire date to term date (if both are in the same calendar year) or year to date (if hired in a previous year)

That's not cheating. That's what the setting is for. And it will significantly reduce the tax rate on any fat checks.

Are you planning to let someone go? 

Do you want to do all you can to help them land on their feet? 

Let's Talk