By: Gregg Zeff
On: August 29, 2025
In post-employment financial planning, it’s important to understand how the taxation on severance packages works. Severance pay is deemed as taxable income at both the state and federal levels. For residents of Pennsylvania and New Jersey, there exists variations in how severance pay is taxed.
Federal tax laws are relatively standardized, however each state adds its own nuances to the myriad of tax laws. Managing finances during these periods of employment transition have proven that careful consideration of tax liability is a necessity.
Table of Contents:
- How Severance Pay Is Taxed at the Federal Level
- State Income Tax Rules: New Jersey vs. Pennsylvania
- Tax Planning With Retirement, 401(k), and IRA Rollover Options
- Common Penalties & Mistakes in Severance Tax Reporting
- How Severance Pay Affects Unemployment Benefits
- Severance Payout Examples in New Jersey and Pennsylvania
- Why Consulting an Employment Lawyer Matters for Severance Packages
- Additional Severance Tax Planning Resources
How Severance Pay Is Taxed at the Federal Level
Federal tax authorities treat severance pay as a supplemental wage. Severance pay at the federal level is subject to federal income tax, Social Security, and Medicare (FICA) taxing. As for taxing supplemental wages at the federal level, two options exist: flat rate and percentage methods. FICA taxes, Social Security and Medicare, also take a bite out of severance pay. For those who receive severance, a critical component and consideration of these packages is whether they are paid out as either lump-sums or installments. This can significantly impact tax liability. Severance recipients, unfortunately, can find themselves pushed into higher income tax brackets and burdened with significantly greater tax bills when receiving lump sums. Former employers that agree to severance installments that span beyond a single tax year can minimize tax burden.State Income Tax Rules: New Jersey vs. Pennsylvania
While standardized taxation of severance pay exists at the federal level, there exists a number of variations within the state. New Jersey utilizes a progressive income tax system. In the Garden State, tax increases with the rise of taxable income. In the case of large lump-sum payments, New Jersey residents may find themselves pushed into higher tax brackets. Also the state requires employers to treat severance payouts in the same manner as regular wages, thus incurring greater tax withholdings. Pennsylvania employs a flat income tax rate of 3.07%. Pennsylvania’s tax rate does not fluctuate due to the amount of income and offers up a level of predictability unlike its neighbor. Just like their New Jersey counterparts, Pennsylvania employers are required to withhold state income tax from severance pay. Severance pay in Pennsylvania may also be subject to local earned income taxes, depending on the municipality, however, some income such as unemployment compensation is deemed as tax-exempt. For recipients of severance in pay in both states, the entire payment amount is considered taxable income. Where the states vary is in the tax structure itself. For residents in either state, it’s important to understand how severance taxation works to avoid unforeseen tax burdens.How Payout Timing Affects Severance Taxes
To optimize your severance benefits, timing is everything. It’s important to carefully plan and consider when former employees select lump-sum or installment payouts. While lump-sum payment options may provide immediate financial relief and security, it may unfortunately move the recipient into higher tax brackets and create an unforeseen tax burden. Utilizing an installment approach to spread the severance pay out over two years can significantly lessen their tax liability. This timing however can impact unemployment eligibility in both New Jersey and Pennsylvania.
Tax Planning With Retirement, 401(k), and IRA Rollover Options
Another consideration for tax planning is to utilize retirement or tax-advantaged accounts. Since the Internal Revenue Service (IRS) considers severance pay as earned income, it can be used to fund individual retirement accounts (IRAs) up to their annual limit. Salary-continuation severance pay may be used to increase your 401(k) contributions, however if the IRS deems the payout as post-severance compensation and not connected to services rendered, it may not be eligible for 401(k) contributions. Similarly, health savings accounts (HSAs) can be advantageous, yet if the individual is no longer covered by a high-deductible health plan, then severance may not be used in health savings accounts.Common Penalties & Mistakes in Severance Tax Reporting
The most common mistake in severance tax reporting is under-reporting income. When reported income does not match the employer’s issued W-2 form that is on file, it can trigger an audit or request for clarification. The subsequent consequences of such mistakes include an unexpected tax bill along with the potential of additional charges and interest. It’s important to keep accurate records and copies of your W-2 forms to ensure the proper amount of income has been reported.How Severance Pay Affects Unemployment Benefits
An important factor on the timing of receiving a severance package has potential impact on unemployment eligibility and benefits. Differentiation between earned wages or a lump-sum payment for past service versus salary continuation can significantly hinder unemployment benefit eligibility. For Pennsylvanians, severance pay is generally considered compensation and can reduce or offset unemployment benefits, regardless of lump-sum or installment payments. Residents of New Jersey must be aware that a lump-sum severance payment is generally not considered an extension of employment and does not affect unemployment benefits. Installments are considered a salary continuation and may be viewed as an extension of employment and could delay the start date for receiving unemployment benefits. Understanding how their employer’s severance offer is structured and how that structure interacts with state unemployment regulations to strategically preserve their eligibility for benefits.Severance Payout Examples in New Jersey and Pennsylvania
As a comparison of the severance tax burden between New Jersey and Pennsylvania consider the follow case:- An employee in New Jersey receives a lump-sum severance of $40,000 combined with their $80,000 salary. The combination of this income would be reported as $120,000 and in conjunction with New Jersey’s progressive taxation system would find their tax obligation jump from the 5.525% bracket to the higher bracket of 6.37%. Spreading the severance sum out of two years may prevent such elevated tax burden.
- That same employee in Pennsylvania would find their $40,000 severance pay taxed at the flat rate of 3.07%, the same as their regular wage.
