Getting laid off is never fun. But at least you might get some severance pay. These are payments employers make to terminated employees, typically when they are laid off.
In most states employers are not legally required to make any severance payments, unless an employment contract requires it. But employers often do so anyway. For one thing, severance pay can be a cheap way to avoid lawsuits, since employees are usually required to waive all legal claims against the employer before the money is paid.
Amounts vary, but one or two week's pay for every year of service is a common severance payment amount. So such payments can be substantial.
Ordinarily, employees and employers each pay a 6.2% Social Security tax on employee wages up to an annual cap, plus a 1.45% Medicare tax on all wages, for a total 15.3% tax up to the annual cap. Together these taxes are known as FICA, payroll, or employment taxes. The employer withholds the employee's taxes from his or her pay and sends it to the IRS along with its own matching payments. So this is money the employee never sees.
FICA taxes must be paid only on employee wages. Since severance payments are paid to you after you're done working for an employer, you might think they don't constitute employee wages for FICA purposes. You might think that, but you'd be wrong.
The United State Supreme Court says severance payments are wages and are subject to regular FICA taxes. The Supreme Court reasoned that such payments are paid as remuneration for employment, so they are wages. (Quality Stores, Inc., 134 S. Ct. 1395 (2014).)
In addition, severance payments are classified as "supplemental wages" for income tax purposes. Employers must withhold income tax from such payments at a flat 22% rate and pay the money to the IRS. State income tax must be withheld as well in the 43 states that have income taxes.
Keep these tax rules in mind if you have the opportunity to negotiate a severance pay package. You may be able to get your ex-employer to "gross up" your severance pay. This means taking the base amount of the severance payment and adding an additional amount to cover the taxes due. Employers are not required to this, but may agree to do so depending on the circumstances.
To calculate how much to gross up your severance pay, add the percentage amounts of all the taxes due--this includes:
Subtract this percentage amount from 100%. Then divide the base severance payment by the result. For example, assume your base severance payment is $40,000. The total employee FICA, income, and state tax due on the payment amounts to 35%. Subtract 35% from 100%, leaving 65%. Divide $40,000 by 65%, resulting in $61,538. You need to be paid $61,538 to end up with $40,000 after tax.