If you’ve recently been laid off, you’re probably concerned about the tax implications of your severance pay. You don’t need to feel overwhelmed or intimidated by the process.
Severance pay is taxable in the year that you receive it. So, if you’re receiving three-months’ worth of pay, you’ll need to factor in taxes to that amount.
There are a variety of tax planning strategies that you can take advantage of to help lower your tax burden. In this article, we’ll explore six of the best ways to reduce your tax liability on your severance pay.
1. Maximize Your Retirement Plans
Maximizing your retirement plans can be the key to reducing your tax burden on a severance payout.
Contributing to tax-deferred accounts like an individual retirement account (IRA) is an easy and effective way to pay less taxes on severance pay. Some employers may also allow you to put your severance pay into your 401(k) retirement plan.
The contribution limit for IRA is $6,500 for 2023. You can put in an additional $1,000 if you’re over 50, which counts as a catch-up contribution.
2. Contribute To Your Health Savings Account
For those with high-deductible health insurance plans (HDHPs), putting your severance money in a health savings account (HSA) is a great way to plan for future expenses if you don’t want to put it toward retirement.
An HSA is a tax-deductible savings account that can be used to pay for medical expenses if you’re enrolled in a high-deductible health insurance plan.
You can contribute up to $3,850 for yourself or a maximum of $7,750 for your whole family in 2023.
3. Put Money Away For College In A 529 Account
If you have kids or want to support a young niece or nephew’s college education, consider using your severance pay to invest in a 529 plan. You may even get some state deductions for contributing.
Some states may offer additional tax credits for 529 contributions, which can help reduce your tax rate on your tax return. The SECURE Act of 2019 also allows you to use a 529 to pay off up to $10,000 of your own student loan debt, making it an even more attractive option.
There is no annual limit but each state sets the aggregate limit for 529 accounts. The totals vary but could be as high as $550,000. This means that most families won’t have to worry about hitting their 529 plan’s contribution limit this year. However, if you exceed the gift tax exclusion in a year, then you might trigger a gift tax.
In 2023, gifts totaling up to $17,000 per individual will qualify for the annual gift tax exclusion. Individuals may contribute as much as $85,000 to a 529 plan in 2023 if they treat the contribution as if it were spread over a 5-year period. The 5-year election must be reported on Form 709 for each of the five years.
Any gifts above the annual exclusion amounts will have to be reported on the federal tax Form 709, and these will be counted against the $12.92 million lifetime gift tax exclusion.
4. Spread Out Your Termination Pay Over Several Years
Receiving a single large lump-sum payment could push you into a higher tax bracket this year.
An easy way to pay less taxes is to have your severance paid out in two separate years. By spreading out the payments over two years, you can lower your taxable income in the year you receive the severance pay, which can help you minimize the amount of taxes you owe on the money. Doing this can help you to reduce your tax bill and avoid a big tax bill in one year.
5. Manage Your Investment’s Capital Gains and Losses
If you have unrealized capital gains on your company stock and investment portfolio, you need to plan carefully to ensure any capital gains from stock sales or rebalancing activities don’t drastically increase your gross income and the amount of tax you will pay.
If you have capital losses to harvest, it might be worth considering them. For tax purposes, you can offset $3,000 per year of ordinary income using capital losses.
You should work with a financial planner to plan out the best way to manage your capital gains and minimize the taxation of your severance pay.
6. Contribute and Invest In a Donor-Advised Fund
Contribute to a donor-advised fund to reduce your tax burden while supporting your favorite organization. A donor-advised fund allows you to contribute money and receive a tax deduction for the contribution while giving you the flexibility to decide which organizations to support over time.
It’s a great way to offset the taxes you’d pay on your severance and still support a cause you’re passionate about. You can contribute to a donor-advised fund with cash, stocks, or mutual funds, and you can even use funds from a 529 plan.
It’s essential to read carefully through the rules before contributing to ensure your contribution doesn’t count as a gift. A financial advisor can advise you on how to use a donor-advised fund to reduce your tax liability on your severance pay.
You don’t have to let your severance pay leave a big tax bill. With the right planning strategies, you can reduce your tax liability and ensure you’re getting the most out of your hard-earned money. With the right tax planning, you can make the most of your severance pay.