Some states treat severance the same as federal law and apply a flat withholding rate, while others require employers to calculate the tax based on the employee's highest marginal tax bracket. For many years, the standard rule dictated that any supplemental wages, including severance, were subject to a flat 22% federal withholding rate if paid separately from regular wages.
Strategic Tax Planning to Minimize Severance Pay Tax Liability
The Lump Sum and Annual Tax Reconciliation It is important to understand that the high withholding rate is an estimate, not the final tax bill. Unlike federal rules which provide a flat rate, state tax treatment of severance varies significantly.
When the employee files their annual tax return, the severance income is added to their total taxable income for the year. While this can sometimes lower the supplemental rate, it risks bumping the total income into a higher bracket for that specific pay period.
Strategic Planning to Minimize Severance Tax Liability
In high-tax states like California or New York, this can result in state withholdings of 9% to 13%, effectively stacking the state tax burden on top of the federal 22%. The reason severance pay taxed at a higher rate stems from how the Internal Revenue Service (IRS) classifies these payments, treating them not as a simple gift, but as a form of compensation that requires the highest withholding rates.
More About Why is severance pay taxed at a higher rate
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