Getting laid off or leaving a job can feel like a huge life shift. In some cases, you may receive severance pay, which can offer a financial cushion while you figure out your next move. At first, that lump sum of money feels like a relief. But then reality hits when you realize just how much of it will go to taxes.

Severance pay is considered taxable income by the IRS. That means it is subject to federal income taxes, state income taxes, Social Security, and Medicare taxes. So even though your severance package might look generous on paper, you may end up taking home much less than expected.

For some people, receiving severance pay can feel like an opportunity to catch up financially, perhaps even put a dent in medical debt relief or other outstanding obligations. While that is a good start, smart tax planning can help you hold on to more of that severance money and reduce the tax hit that comes with it.

Get Professional Help

The tax implications of severance pay can be complex, especially if you are also dealing with unemployment benefits, retirement plan payouts, or medical debt relief strategies. Hiring a qualified tax professional to review your situation can save you significant money and stress in the long run.

They can help you create a personalized plan that considers your total income, deductions, and opportunities for tax savings, ensuring you keep as much of your severance as possible.

Understand How Severance Is Taxed

Before diving into tax saving strategies, it helps to understand how severance pay is treated. Severance is taxed as regular wages, meaning your employer withholds taxes from the payout just like they do from your paycheck. However, because severance is often paid in a lump sum, the withholding can push you into a higher tax bracket temporarily, leading to a bigger chunk being taken out upfront.

Sometimes, people mistakenly believe that severance is taxed at a higher special rate. That is not true. It is taxed based on your overall income for the year. The more you make, the higher your tax rate on that income.

Negotiate How Severance Is Paid

One of the most effective ways to minimize taxes on severance pay is to negotiate how you receive it. If your employer is open to it, spreading out the payments over two tax years can reduce your taxable income in each year, potentially keeping you in a lower tax bracket.

For example, if you receive half your severance in December and the other half in January, you may avoid pushing yourself into a much higher tax bracket in one year. This approach works best if your total income will drop significantly after losing your job.

Contribute to Tax-Advantaged Accounts

Another way to reduce your taxable income is to contribute part of your severance to tax advantaged accounts. If you are still eligible to contribute to a 401(k), IRA, or Health Savings Account (HSA), you may be able to lower your taxable income for the year.

For example, contributing to a traditional IRA reduces your taxable income for that year. If you have an HSA, contributing the maximum allowed amount can also provide a tax deduction while helping you cover future medical expenses.

Keep in mind that you will need earned income to qualify for some of these contributions, so timing is important. Check with a tax advisor to ensure you meet the eligibility rules.

Take Advantage of Unemployment Periods

If you do not find a new job right away, your total income for the year may be much lower than usual. This can reduce your overall tax liability on your severance pay. In some cases, you might even qualify for certain tax credits or deductions that you would not normally be eligible for when employed full time.

Consider working with a tax professional who can help you analyze your entire tax picture and identify deductions or credits you may qualify for during this transition period.

Deduct Job Search Expenses

While job search expenses are no longer deductible for most taxpayers under current tax laws, it is still worth staying informed about any potential changes. In the past, expenses like resume services, travel for interviews, and professional coaching were deductible. If these deductions return in future tax years, they could offer additional ways to offset taxable income during unemployment.

Avoid Making Large Purchases Right Away

It can be tempting to spend severance money quickly, especially if it feels like free money at first. But before making big purchases, wait until you fully understand how much you will owe in taxes. The last thing you want is to spend most of your severance, only to discover you owe a hefty tax bill come April.

Instead, set aside a portion of your severance for tax obligations right away. A general rule of thumb is to assume you may owe between 20 to 30 percent of your severance for federal taxes, depending on your income level, plus any state taxes if applicable.

Consider Estimated Tax Payments

Since severance can significantly increase your income for the year, you may end up owing additional taxes when you file. To avoid penalties for underpayment, it may be wise to make estimated tax payments throughout the year. This spreads out your tax liability and helps you avoid a large lump sum payment when you file your return.

A tax professional can help you calculate whether estimated payments are necessary and how much you should pay each quarter.

The Bottom Line: Plan First, Spend Later

Receiving severance pay may feel like a lifeline during a difficult time, but it comes with strings attached in the form of taxes. Without proper planning, you could end up with less money than you expected.

By understanding how severance pay is taxed, negotiating your payout structure, contributing to tax advantaged accounts, and working with a tax advisor, you can minimize your tax liability and make the most of your severance package. Taking the time to plan now can help you stay financially stable while you navigate your next career move.