Getting fired is never good news, but if you get a severance package, it can be a boon for your savings account. It allows you to train as you look for a new job, increase your emergency fund, or pay off debt. But one thing many people don’t consider is that they have to pay taxes on severance payments. Thankfully, there are several ways to reduce the tax burden. Read on to find out how to reduce your taxes to Uncle Sam.
- You can reduce your tax bill by sending severance payments to the IRA.
- If you have a high-deductible health insurance plan, consider putting some of your severance payments into your HSA.
- Ask your employer if the company can pay you within two years.
- You can use some of the money in the package to fund a 529 plan.
- Consider putting your severance payments into a donor-advised fund to support your favorite charities.
Contribute to a retirement account
An easy way to reduce your severance pay tax is to contribute to a tax-deferred account such as an individual retirement account (IRA). The contribution limit for the 2021 tax year is $6,000. If you’re over 50, you can contribute an additional $1,000, which counts as a catch-up contribution.
Financial experts say you should save as much money as possible.According to brunch and budget Pamela Capallardas a Certified Financial Planner (CFP), you should try to contribute as much as possible if you can take advantage of this opportunity.
Some employers may even allow you to put severance payments into your 401(k). The 2021 limit is $19,500. If you’re over 50, you can save an additional $6,500.
use it for medical expenses
For those with a high-deductible health insurance plan (HDHP), putting severance payments into a health savings account (HSA) is a great way to plan for future expenses if you don’t want to use it for retirement.
You can contribute up to $3,600 for self-insurance, or up to $7,200 for a family plan, as long as the following conditions are met:
- Your deductible is more than $1,400 (self-insured) or $2,800 (home insurance)
- Your out-of-pocket costs up to $7,000 or $14,000 for out-of-pocket and home insurance, respectively
You can save up to $3,650 on self-insurance or up to $7,300 on a family plan as long as you:
- Your deductible exceeds $1,400 for self-insurance or $2,800 for home insurance (same as 2021)
- Your out-of-pocket costs are up to $7,050 or $14,100 for out-of-pocket and home insurance, respectively
An easy way to reduce your taxes is to pay severance payments over two years. Ask if you can spread out your payments to avoid a huge tax hit in a year. For some, a lump sum payment may mean taxes owed to you.
“Receiving a large one-time payment could push you into a higher tax bracket,” according to Taylor Landers CFP, Accredited Investment Trustee (AIF) and founder of Tandem Financial Guidance. “It could mean a huge change in how much you owe.”
Make sure you get advice from a financial professional to get the best tax benefits based on your personal circumstances.
Open a 529 plan
If you have children or want to support a young niece or nephew’s college education, consider using your severance pay to invest in a 529 plan. You may even get some state deductions for donations.
Please read the rules carefully to see the restrictions, so your contribution does not count as a gift. When you’re trying to reduce your tax burden, you don’t want to give yourself more headaches.
You can also use your 529 to pay off up to $10,000 of your own student loan debt under the Strengthening Retirement for Every Community (SECURE) Act of 2019. It may make sense to open a 529 account, get any available state tax credits, and pay off your student loans immediately.
Invest in donor-advised funds
Donor Advised Funds are a unique way for you to offset the taxes you pay on severance payments while supporting your favorite organizations. The best part of a donor-advised fund is that it allows individuals to receive tax benefits while having a say in how organizations get their money.
“These accounts are sponsored by national charities that save your donations and let them grow for future distributions or grants,” Landers said.
Once you find yourself receiving severance pay but don’t know what you want to do, consult a professional. Even if you think you know what’s best, a certified public accountant (CPA), CFP, or other financial professional can give you ideas on how to use your money.
“A buyout is a real gift, so plan accordingly,” says Peter J. Creeden, CEO of Crystal Brook Advisors. “You need to know and understand the big picture before making major financial decisions.”