Are Severance Packages Taxable?

Both severance pay and unemployment benefits are taxable as income, which comes as pretty bad news to those who have just lost their jobs.

If you have recently lost your job, you may be making ends meet through severance pay, other job-related compensation (such as vacation pay your employer has cashed out, your final paycheck, or other amounts you have earned, such as commissions), or unemployment insurance. If so, here’s some bad news: Even though you are temporarily out of work, you still have to pay income tax on these amounts.

Tax on Severance Pay and Compensation

The basic rule is that you must pay income tax on severance pay. For example, if your employer pays one week of severance for every year of service, that money will be treated as income — and you’ll have to pay income tax on it — in the year your receive it. Based on your anticipated earnings, you might want to ask your employer to defer some or all of your severance to the next tax year, if that would save you some money (and you can afford to get by without it for a while).

The same is true for other amounts paid to you by your employer, such as your final paycheck or unpaid commissions. A number of states require employers to pay employees for their unused, accrued vacation time: This money is taxable as well. Although it isn’t generally legally required, some employers also cash out unused sick leave or annual leave. These amounts are also taxable.

Tax on Unemployment Benefits

Believe it or not, you also have to pay federal income tax on unemployment benefits. Some states also consider unemployment to be taxable income; others don’t.

Deductions That May Be Available

The small silver lining is that you may now have deductible expenses relating to your job search, which can lower your overall tax bill. Depending on your situation, these may include:

  • job search expenses, such as outplacement fees or the cost of printing and copying your resume
  • travel expenses to look for work or participate in interviews
  • the cost of health insurance (at least in part), and
  • some tuition expenses, if you decide to go back to school and brush up your skills or improve your qualifications.

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