is a severance package taxed

is a severance package taxed

Tax Options for Severance Packages

Flexible benefits let employees put aside pre-tax income for medical and other qualified expenses.

The need to terminate workers is a reality that many businesses face, regardless of the company's size or the employee's history. Severance packages can help offset the loss of income that comes from losing a job. Employers can also help their workers manage severance package options to avoid paying too much in taxes, both at the time of termination and into the future.

One of the key decisions an employee needs to make that impacts taxes on a severance package is whether to take a lump sum payment or opt for salary continuation. In general, all income from a severance package is taxable. A lump sum means a higher tax liability for the year in which the employee receives it. Spreading payments out with salary continuation may place some of that income in a future tax year, depending on the length of the severance package and the time of year when it begins.

Severance package recipients can take steps to defer income tax on some of the money they receive. This is especially useful for workers who lose their jobs close to retirement. Placing money in an annuity or individual retirement account creates the opportunity for a tax deduction. Although the severance income is taxable, it also counts as a deduction from taxable income if it goes into a qualified, tax-deferred retirement plan. Maxing out such contributions will minimize the tax impact of a severance package and allow the recipient to pay taxes at a lower rate as the money is withdrawn.

Workers who receive severance pay are generally not eligible for state unemployment benefits, at least until their severances expire. This means receiving severance income is partially offset by the loss of unemployment benefit income, which is also taxable. Individuals who receive income from regular wages, severance packages and unemployment benefits during the same tax year are responsible for paying taxes on total income for the year.

However an employee receives income from a severance package, investing some or all of the money, whether to defer taxes or simply to set it aside for the future, has its own long-term tax implications. These issues rely on how the money is invested. For example, a worker who buys stock with money from a severance package will need to pay income tax on the full amount. He will also be liable for taxes on any dividends he receives and capital gains he realizes when he sells the stock. This holds true even many years after the severance package is offered, making severance tax planning an important decision toward a worker's financial future.

How severance packages are taxed

This article was first published in the third quarter 2016 edition of Personal Finance magazine.

Retrenchments have become a common occurrence as companies struggle to stay profitable in the current economic climate.

As prescribed by the Basic Conditions of Employment Act, a severance package must be paid to a retrenched employee at a minimum rate of one week’s salary for every year of service. If you do not have many years of service, or your salary is relatively small, this package might not be sufficient to maintain you until you find a new job. This can force you to dip into your retirement fund. How are such withdrawals taxed under these circumstances?

This is best explained by using an example: John, who is 53, has worked for BDY Company for a number of years and was retrenched in January 2016. He receives a severance package of R600 000, pay in lieu of leave of R30 000, a pro rata share of his annual bonus of R80 000 and a final salary of R40 000. He decides to take R400 000 from his pension fund and to invest the balance in a preservation fund until his retirement.

The first thing to note is that any leave pay, pro rata bonus and final salary do not form part of the severance package and are taxed according to normal income tax rates.

From March 1, 2011, a concession has applied that makes all severance benefits taxable according to retirement tax scales (refer to this table) if one of the following requirements is met, as provided for in section 1 of the Income Tax Act:

* You are 55 years or older;

* You are incapable of holding employment because of sickness, injury or incapacity; or

* The termination or job loss is a result of one of the following:

– Your employer ceased to carry on, or intends to cease carrying on, the trade in respect of which you were appointed; or

– You have become redundant as a consequence of a reduction in personnel by your employer.

A severance package must meet one of the above requirements to be taxed at the retirement tax scales.

Remember that John is receiving a severance benefit of R600 000 and will take R400 000 from his pension fund – a total of R1 million.

It is important to remember that the South African Revenue Service (SARS) applies the aggregation of lump sum principle, so all lump sums withdrawn from retirement funds – past, present and future – are aggregated, or added together. In other words, the following lump sums must be aggregated when the tax is calculated on the current lump sum that John is taking:

* All withdrawal lump sums after March 1, 2009;

* All retirement lump sums that accrue after October 1, 2007; and

* All severance benefits after March 1, 2011.

John’s tax calculation will be as follows (refer to the sliding scale in the table): [(R1 million – R700 000) = R300 000] x 27 percent + R36 000 = R117 000.

The employer must submit a tax directive application to SARS before the lump sum can be paid.

Although a severance benefit is taxed as a retirement lump sum, the lump sum cannot be preserved in the employer’s retirement fund, or in a preservation fund. The after-tax lump sum can, however, be invested in a retirement annuity (RA) fund.

It is important to take note of the new section 3(2)(bA) of the Estate Duty Act, which became effective on January 1, 2016 and is applicable to the estate of anyone who dies on or after that date in respect of contributions made on or after March 1, 2015. In terms of section (bA), if John were, for example, to make his after-tax benefit (say, R550 000) payable to an RA as a lump sum (after March 1, 2015) and then pass away after January 1, 2016, any contributions that he had not been able to deduct (that is, contributions in excess of 27.5 percent of the greater of taxable income or remuneration) would be added in as a deemed asset for estate duty purposes.

In conclusion, it is important to remember that you receive the tax-free amount (R500 000) only once, so if you take it earlier, it will not be available to you again on retirement. An additional lump sum taken on retirement would then be taxed according to the sliding scale below. So it’s important, if you are retrenched, to contact a professional person who can assist with advice about tax and investments.

* Daleen Harris is a member of the Fiduciary Institute of Southern Africa, has the Certified Financial Planner accreditation and is a legal adviser specialist at Old Mutual.

At some point, you might have to terminate an employee. You might eliminate their position, make layoffs, fire for misconduct, or mutually part ways.

No matter the reason, you might consider giving the employee severance pay. Before you make a decision about severance pay, learn more about it, what you might give and when, and how to pay severance wages.

Severance pay is compensation you can give an employee when they lose their job. While the Fair Labor Standards Act (FLSA) provides rules for employee wages, it does not require you to provide severance pay. Your state’s laws might require severance pay in some situations, such as for large layoffs and business closures.

In most situations, it is your decision to give or not give severance pay.

Should you provide severance pay?

Severance pay can reduce the impact of a job loss on an employee. The extra pay can help the employee cover expenses until they find a new job.

Typically, employers only give severance pay for layoffs, job eliminations, and mutual agreements to terminate employment. Employers generally do not give severance pay when firing employees for misconduct.

You should make your severance pay policies clear. Include your terms in your employee handbook and/or the employee’s contract. If you promise severance pay in writing, you should give it.

Even if you don’t include severance pay in an employee’s contract, you can still choose to give it later. No matter what you do, be consistent in giving out severance pay. You should not discriminate.

Some employers give severance pay in exchange for the employee’s signature on an agreement that says they won’t sue your business for anything. This protects your business and gives the employee some financial stability.

How much severance pay should you give?

There is no standard amount of severance pay to give. You can decide what to give.

Severance pay is often based on how long the employee has worked for you. For example, you might give one week’s pay for every year the employee worked for you.

The severance pay is negotiable. Be prepared to negotiate with the employee and know how far you are willing to go.

Can I include other things in a severance package?

When an employee is terminated, you can give more than just wages. Below are common items that are included in severance packages.

Insurance and benefits: If you have at least 20 full-time equivalent employees and offer a health group plan, you must provide COBRA continuation coverage. COBRA coverage lets former employees keep their health insurance benefits for approximately 18 to 36 months.

You might also voluntarily continue the employee’s other benefits. For example, you might continue the employee’s retirement plan and life insurance.

Uncontested unemployment benefits: When a former employee files for unemployment benefits, you have the opportunity to contest the claim. If you don’t contest the claim, the former employee has a better chance of receiving benefits. As part of the severance package, you can promise not to contest the claim.

Letter of recommendation: When an employee leaves, give them a letter of recommendation that can help them find another job.

Equipment: If the employee used any company equipment to do their job, you might let the employee keep those items. For example, you might let the employee keep their cell phone and laptop.

Unused vacation and sick days: The employee might have unused accrued vacation and sick days. You can pay out this unused time, so the employee still benefits from them. Your state laws might require you to pay out the unused time.

There are two ways to give out severance pay: a lump sum or regular installments. You can choose how to pay the severance compensation.

A lump sum is the full amount of severance pay given upfront. The large amount might be difficult for your business to pay out at once. But with a lump sum payment, the former employee is more likely to qualify for unemployment compensation in following weeks.

With regular installments, you give the severance pay in smaller amounts and in spaced out intervals. The installments might follow your business’s normal pay schedule. Installments might help your business better bear the severance pay amount. And, regular payments can help the former employee create a budget. However, as long as the former employee receives pay from you, they might not be eligible for unemployment benefits.

Severance pay is taxable. Withholding on severance pay includes all federal, state, and local taxes. Payroll taxes on severance pay include income taxes, federal income tax (FUTA tax), Social Security tax, and Medicare tax.

Include the severance pay and the taxes paid on the former employee’s Form W-2.

Is severance pay taxed at a higher rate than regular wages? For FUTA, Social Security, and Medicare taxes, severance pay is taxed at the usual rates. For federal income taxes, the amount you withhold depends on the amount of the payment. If you give a lump sum, the payment might be subject to increased income tax withholding because the payment is within a higher tax bracket than the employee’s regular paychecks.

Additional items in the severance package might also be taxable. For example, you should withhold and pay taxes on vacation and sick time payouts.

For more information on taxes for severance pay, see Publication 15 (Circular E), Employer’s Tax Guide, and Publication 525, Taxable and Nontaxable Income. Publication 4128, Tax Impact of Job Loss, might also be helpful, but it is written for employees who have lost their jobs.

Do you need to give severance pay to an employee? You can include it as a money type in Patriot’s online payroll software. We’ll accurately calculate the taxes and include the severance pay on the former employee’s Form W-2. Start using our online payroll software for all your employees. Get your free trial today.

This article is updated from its original publication date of 6/11/2012.

This is not intended as legal advice; for more information, please click here.

If I take a severance package from my employer, how will it be taxed?

It depends on your tax bracket. For instance, if your employer offers you a payout of $100,000, you will owe federal tax of $35,000. You may also owe estate tax.

It may be best to check with your tax professional; he or she may be familiar with your tax rate and know whether any other taxes will apply.

This question was answered by Denise Appleby

Loss of employment through retrenchment (forced or voluntary) is a reality many employees face in the current economic climate. Over the last number of years, various tax concessions have been made to ease the financial burden on employees facing retrenchment, mainly in the form of tax free thresholds which apply to certain lump sum employer payments.

Navigating the tax pitfalls of retrenchment is important, as it is not necessarily guaranteed that all forms of payment upon retrenchment will qualify for preferential tax treatment.

Currently, the Income Tax Act, No 58 of 1962 (Act) provides for a R 500,000 lifetime exemption (effective 1 March 2014) in respect of a "severance benefit". A "severance benefit" for the purposes of the Act is, essentially, any employer paid amount (excluding retirement fund lump sums) received by or accrued to a person by way of a lump sum in respect of the relinquishment, termination, loss, repudiation, cancellation, or variation of office or employment, provided at least one of the following requirements is satisfied:

  • the person has attained the age of 55;
  • the termination or relinquishment of office is due to sickness, accident, injury, or incapacity through infirmity of mind or body;
  • the termination or loss is due to the employer having ceased, or intending to cease, carrying on the trade in respect of which the person was employer; or
  • the termination or loss is due to the person having become redundant in consequence of a general reduction in personnel or a reduction in personnel of a particular class.

Qualification of an amount as a "severance benefit" needs to be carefully considered where the termination or loss is due to the person having become "redundant" in consequence of a general reduction in personnel or a reduction in personnel of a particular class. In certain cases, the affected employees are offered a Voluntary Separation Package (VSP) and the following question arises: Does a payment in the form of a VSP pursuant to redundancy, qualify for tax preferential treatment?

There is no definition of "redundant" in the Act and as such, it should take on its ordinary meaning for tax purposes, bearing in mind that the concept of redundancy bears its own meaning for labour law purposes.

Based on the fact that a VSP process is essentially a bilateral negotiation between the employer and the employee, there is a school of thought that any payment resulting from the voluntary termination process does not fall within the definition of "severance benefit". The reason being that the payment was not as a result of the employee's position becoming "redundant". In other words, in order for an amount to (seemingly) qualify as a "severance benefit" (incorrectly in our view), it needs to be paid as a result of an employer's unilateral decision or, stated differently, a forced retrenchment.

It is arguable that, but for the general reduction of personnel by the employer, there would have been no payment and that the structure of the "severance benefit" definition is such that it contemplates a process (ie a legislated labour law process), which ultimately culminates in a particular employee being regarded as "redundant", which then results in the payment of an amount taking the form of, among other possibilities, a VSP.

When an employer embarks on a VSP process, the employer has already made a decision to effect a general reduction in employees. It follows that, once an employee elects to receive a VSP, the employee accepts that he or she is "redundant" and the payment made by the employer, as a consequence of the VSP, is a payment that the employee would not have received, had he or she not been affected by the proposed redundancy. The interpretation that being "redundant" only contemplates the result of a forced retrenchment is, in our view, too narrow, as the decision to make a "general reduction" in personnel is part of a wider process that, by implication, includes a voluntary element. It may, however, be required by the particular employer to completely remove the affected position function from its organisational structure, despite the process being inherently voluntary.

Employers, therefore, need to tread carefully and plan accordingly where a retrenchment process is contemplated, so as to ensure that a VSP results in the most tax effective outcome for affected employees. Employers should also be careful not to oversell a VSP where the VSP arguably does not fall within the requirements of a tax-free "severance benefit".

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