Laid-Off Workers May Face a Tax Gap Due to Severance Withholding
Workers receiving severance pay after being laid off may face unexpected tax shortfalls due to federal withholding rules. Employers are required by the IRS to withhold 22% from supplemental wages like severance, but this rate often underestimates what is actually owed when combined with prior annual income. For example, a senior manager earning $200,000 before being laid off and receiving a $60,000 severance could end up owing closer to 32% in taxes on that amount during tax season—resulting in an unexpected shortfall of over $6,000. This occurs because the IRS treats severance as part of total annual income, pushing it into higher tax brackets when combined with prior wages. The discrepancy arises from how supplemental pay is taxed separately but then merged with other earnings for final calculations on Form 1040. Workers who have already spent their withheld funds may face penalties if they do not prepare in advance by adjusting withholding or making estimated payments before the end of the year. The IRS allows individuals to file Form 1040-ES, increase W-4 withholdings, or use an HSA as strategies to close this tax gap and avoid underpayment penalties. This issue highlights a common financial challenge for laid-off workers who may not anticipate how their severance will interact with prior earnings when calculating taxes. Understanding these rules can help individuals better plan financially during periods of transition.
Topics: IRS rules laid off workers severance taxes