The tax of severance

Why the deposit was smaller than the number in the agreement

Your agreement said a number. Your bank showed something much smaller. Here is where it went.

Federal income tax withholding. Severance is a supplemental wage. Employers commonly use the optional flat rate, which for 2026 is 22 percent, rising to 37 percent on supplemental wages above $1,000,000 in a calendar year.

California income tax withholding. Under EDD’s DE 44, California withholds 6.6 percent on supplemental wages including severance and vacation pay, and 10.23 percent on bonuses and stock options.

Social Security and Medicare. Severance is wages for FICA. The Supreme Court held exactly that in United States v. Quality Stores, Inc., 572 U.S. 141 (2014). So 6.2 percent Social Security up to the annual wage base, plus 1.45 percent Medicare, plus the 0.9 percent additional Medicare tax above the threshold.

California SDI. Withheld on wages at the current rate.

Stack those and a large share of the gross is gone before the deposit lands.

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The single most useful fact in this module

Withholding is not your tax. It is a prepayment.

The flat 22 percent federal rate is applied without regard to your actual bracket, your deductions, your filing status or the rest of your year. It is applied to one payment in isolation.

Your actual tax is computed in April on your whole year. And a year in which you lost a job is frequently a lower income year than the one the withholding implicitly assumed, especially if the job loss happened early in the year.

Two common outcomes:

• You over-withheld. The lump sum was taxed at 22 percent federal when your effective rate for the year turns out to be lower. You get a refund. This is the more common case for a mid-year or late-year separation at a moderate income.
• You under-withheld. A large severance pushed your total income into a higher bracket than 22 percent covers. You owe in April, and possibly an underpayment penalty. This is more common for high earners and for anyone with significant equity income in the same year.

Either way, the number to plan around is your projected total income for the year, not the withholding rate.

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The decisions that actually change the number

1. Timing across tax years

If your separation lands near year end, whether the payment falls in December or January can change which year’s income it joins. For someone who has already earned a full year of salary, pushing a large severance into the following year, when income may be much lower, can be worth real money.

This is a legitimate thing to ask about. The employer can usually accommodate it. Deferred compensation rules under Internal Revenue Code section 409A limit how payment dates can move, and the penalties for getting it wrong are harsh. Do not improvise. Raise it as a question, early, and get advice if the amount is significant.

2. The allocation in the agreement

How the payment is characterized in the document drives how it is reported and taxed. Wages go on a W-2 with employment taxes. Certain non-wage settlement components are reported differently.

The critical point: this gets decided in the agreement, not afterward. Once the W-2 is issued, changing the characterization is difficult. If part of your payment represents something other than wages, the agreement should say so, and say how much.

Relatedly, if components are collapsed into a single “severance” line, you lose the ability to show what was actually settled. See What the pay statement does not say.

3. Attorney’s fees

If you paid an attorney out of a settlement, the gross amount may be income to you even though the attorney received part of it. For claims of unlawful discrimination, Internal Revenue Code section 62(a)(20) provides an above-the-line deduction for attorney fees and court costs, capped at the amount included in income from that judgment or settlement. Outside that category, the treatment is much less favorable since the 2017 tax law. If a settlement involves fees, this is worth real attention.

4. Equity decisions in the same year

A job loss year is often the year you have to decide about options, because the post-termination exercise window is short. Exercising incentive stock options can create alternative minimum tax exposure on the spread even though you sold nothing. Non-qualified options create ordinary income at exercise. RSUs that vest on or before the separation date are wages.

Stacking an equity event on top of a severance payment in a single year is where the large, avoidable tax surprises happen.

5. Estimated tax

If your withholding came up short, you may owe estimated tax. Missing a quarterly deadline can create an underpayment penalty even if you pay in full in April. There are safe harbor rules, often based on the prior year’s tax, that can protect you. Check this before year end, not in April.

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Unemployment benefits are taxable

California unemployment benefits are taxable for federal purposes and not taxed by California. EDD does not withhold federal tax unless you ask it to. If you do not, benefits arrive untaxed and the bill appears in April.

You can request federal withholding on your claim. For many people that is the simpler choice.

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What to keep for tax time

Put these in one folder now:

• The executed separation agreement, complete
• The final pay statement showing how the payment was categorized
• Your last regular pay statement before separation
• The W-2, when it arrives, checked against the pay statement
• Any 1099 relating to the settlement
• Records of COBRA or marketplace premiums paid
• EDD Form 1099-G for unemployment benefits
• Attorney invoices, if any
• Equity exercise confirmations and Form 3921 for incentive stock options

Every spring, people arrive at a tax appointment without the agreement, unable to answer what they were paid for, over what period, and under what terms. This campaign exists to fix that problem. See The three rules.

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One honest caveat

This module is general information, written by an enrolled agent, about how these rules usually work. It is not advice about your return. Severance tax questions turn on specifics: your total income, your filing status, the structure of the payment, your equity, your state of residence during the year, and the exact language in your agreement.

If your severance is large, if equity is involved, or if the payment crosses a year boundary, an hour with a tax professional before you sign is worth far more than the same hour in April.