How do I pay taxes on severance package?

February 11, 2006 11:45 PM

I was just laid off and luckily received a severance package. What do I do about paying tax on it?

I received a lump sum amount for three months pay. However, my employer (very small company) did not take out any of the usual taxes. How do I go about taking care of this? Do I need to pay something now or does it wait until I do my 2006 taxes? What about social security?

posted by anonymous to work & money (8 answers total)

Put aside the amount you would normally have paid in taxes after three months. Invest it in a high interest account until tax time.
posted by acoutu at 12:11 AM on February 12, 2006

I'd plan on seeing that figure listed on the W2 you'll receive this time next year. You are going to have to pay it so you might as well plan for it.
posted by pwb503 at 12:37 AM on February 12, 2006

If no taxes were deducted, and the small company is like many I've worked for, then you're going to have to pay taxes on the full amount come tax time. Acoutu's advice seems sound. The gas station down the street has a sign that sez "THE plus IRS equals THEIRS."
posted by BitterOldPunk at 12:43 AM on February 12, 2006

Assuming this is U.S. and the severance was paid in '06, the tax and SSI will be paid with your '06 return. Since that gives you over a year, you could put the tax portion aside in a 12 month CD.
posted by nakedcodemonkey at 12:55 AM on February 12, 2006

Actually, the IRS and your state (and local?) taxing authorities (don't forget them) require you pay periodically over the course of the year, not just when taxes due are on April 16, 2007. If you follow the advice above and do not do so, it is possible that you may be hit with underwitholding penalties. This year's federal form and instructions, including payment schedule, are here.
posted by mojohand at 7:54 AM on February 12, 2006

From a taxes.yahoo.com page on underwithholding:

You can avoid a penalty for underpayment of estimated taxes if you meet a "safe harbor" payment amount: the smaller of 90 percent of what is ultimately owed or a percentage of the taxes you paid in the previous year. If you make less than $150,000 the safe harbor is 100 percentage of the previous year's taxes.

Example: for 2005, you owed and paid $10,000 in federal taxes (withholding plus/minus payment/refund when you file in early 2006). Assume that you'll owe $11,000 for your 2006 income. When you file next year, the IRS applies the two tests: 90% of $11,000 (what you owe) equals $9,900; 90% of $10,000 (what you paid prior year) is $9,000. So you're okay if you've paid at least $9,000 in 2006.

In practical terms, you probably need to make at least one quarterly estimated payment (in the fourth quarter), and maybe four (one each quarter). [It's not clear to me whether the IRS will penalize you if you don't pay evenly but wait till the fourth quarter; my recommendation, given that interest rates are not that high, is to go ahead and make quarterly payments.]

In any case, absolutely do set aside (ideally, in a separate savings acount or elsewhere) an amount what you estimate you would have paid in federal (and state, if any) taxes that weren't withheld. If you spend it now, you'll regret it.
posted by WestCoaster at 3:18 PM on February 12, 2006

I screwed myself on this once, so I thought it might be worth mentioning. Employer's generally pay half your social security tax, so if they aren't paying that portion for the severence payment, you may want to put aside more than just what you'd paid previously on your taxes.
posted by hootch at 2:56 PM on February 13, 2006

WestCoaster's math is wrong: it's the smaller of 100% of last year's taxes (more if you're over $150k) or 90% of this year's taxes. So, under his figures, the safe harbor is $9,900.

Moreover, unless the $9,900 was reached entirely through withholding, then paying a lump sum estimated tax payment in the fourth quarter may still be considered underwithholding.

Let X = the amount of taxes you paid last year.
Let Y = the amount of withholding that has taken place so far this year.

The safest route to avoid penalties is to make four quarterly payments of (X-Y)/4. This will likely result in a refund next year.

You can do the more complicated formula in the instructions in the link mojohand gave you, and pay the lesser of four quarterly payments of (X-Y)/4 and the formula result, but you'll have to recalculate for each quarter.

Or, if you think you can get a job quickly, when you fill out your W-4, ask for additional withholding. So long as you meet the threshhold through withholding, it doesn't matter when the withholding happens. I did this a lot when I had a job where a third of my income came December 31: I shorted my withholding during the year, and maxed out the withholding for my year-end bonus, and it evened out my income stream.
posted by commander_cool at 9:07 AM on February 15, 2006