Is severance pay taxable in the US?

Severance pay is fully taxable under US federal law. The IRS treats severance as supplemental wages — meaning it is subject to federal income tax withholding, Social Security tax (6.2% on earnings up to the annual wage base), and Medicare tax (1.45%, or 2.35% above $200,000). State income tax also applies in most states. There is no US federal equivalent of the UK's £30,000 tax-free termination payment threshold.

Because severance is often paid as a lump sum, the withholding can be jarring. Employers typically withhold federal income tax on lump-sum supplemental wages at either the flat supplemental rate (22% for amounts up to $1 million, 37% above that) or by aggregating the payment with your regular pay and withholding at the corresponding rate. The actual tax you owe is settled when you file your annual return — you may owe more or receive a refund depending on your total income for the year.

One exception: if severance is paid as a result of a qualifying employment claim or lawsuit (rather than as a standard exit payment), some portion may be characterised differently for tax purposes. Payments for physical injuries or sickness may be excludable from gross income. Non-physical damages are generally taxable. Always consult a tax advisor if your severance was received as part of a legal settlement.