What Is Severance Pay?

If you’ve experienced a job loss, you’ve probably got a lot of concerns and details on your mind. Top of mind are probably how you’ll find a new job and how you’ll make ends meet as you bridge the gap between careers. When parting ways with an employee, some employers offer severance pay, which can help ease some of these worries.

We’ll help you understand what severance pay is and how it works, so you can make informed decisions as you embark on your journey toward a brighter professional future.

What is severance pay?

Severance pay is money paid to an employee as they leave an organization after having been terminated or laid off without cause, which means end in employment was not the employee’s fault. This can happen when an employer restructures or downsizes a department. Being laid off is different from being furloughed, which means that the employee takes a break from working (without pay) but the employer plans on being able to return the employee to normal payroll at some point in the future.

When you involuntarily leave a job, whether or not the end in employment was a result of your job performance is an important factor in determining what benefits you’re eligible for. If you leave due to circumstances out of your control, you can be eligible for severance or unemployment. However, if you’re terminated (or fired) for something under your control—like inappropriate conduct or unsatisfactory performance—you would typically not be eligible for these benefits.

How does severance pay work?

After ending your employment, your employer may offer to continue to pay you for a certain period of time—called severance pay. The amount of severance pay can vary based on factors like years of service with an employer and job level. A generous employer might provide more than money to help their former employee transition between jobs (or from employment to retirement). Severance can be paid to an employee in a single payment or in regular payments over time.

The pay itself can be included as part of a group of benefits.  These can include continued insurance, career consultation services (sometimes called “outplacement”) or other perks like employee discounts, payout of unused sick time or vacation time, stock options or even the option to keep company equipment such as a cell phone.

Employees are free to use severance pay for anything they want. Often it’s used to cover a gap in employment, but depending on your financial situation, there may be a more strategic use for it. A Northwestern Mutual financial advisor can help provide advice on what’s best for you.

Is severance pay required by law?

Each employer determines whether or not to pay severance and how much to provide. Of course, they must honor what was promised in an employment contract, collective bargaining agreement or company policy. But beyond that, no United States law requires severance pay. Unemployment insurance, however, typically is required for employers. Unemployment insurance is a governmental benefit that both you and your employer contribute to, which ultimately results in you being able to collect unemployment if you lose your job.

Though it’s not required, some employers may choose to provide severance pay to boost morale and keep a positive work environment for the employees who remain. If there is a large-scale layoff or prolonged set of layoffs, severance pay can also help protect the employer’s reputation and minimize negative word-of-mouth.

Can you qualify for severance pay and unemployment insurance at the same time?

Depending on where you live, your unemployment benefits could be impacted if you are receiving severance pay. You’ll want to read up on your state to understand how severance might impact your situation. In addition, you might want to talk with an employment attorney or call your state's unemployment insurance agency directly for personalized and accurate information.

Can you negotiate a severance package?

Yes, you can negotiate severance pay and a severance package when you’re hired by an employer just like you would negotiate vacation time or similar benefits. If you’ve been terminated, you can also attempt to negotiate a severance package at that point, but keep in mind: If you don’t have an agreement already in place, an employer is not required to give you a severance package.

You’ll likely discuss terms of your severance with a human resource professional or manager. Before you do so, make sure you’ve researched local labor laws and company policies, and of course, make sure you’re up to speed on any agreements or contracts you previously signed. Think about highlights from your performance reviews and summarize key points of how you have contributed to the organization’s success. While considering your departure, think bigger than your paycheck and determine whether health benefits, outplacement services and/or references would help you most during your transition.

If you’re unsuccessful in securing severance pay, there are other ways to cover the break in income. Hopefully, you’ve built a hefty emergency fund to help you in the short term, and if you need to find other sources of income, a Northwestern Mutual financial advisor can help make recommendations for making ends meet without impacting your long-term goals too significantly.

Is severance pay taxed?

Yes, severance pay is taxed, but how your severance is taxed depends on how your employer distributes it to you.

• If the employer provides severance pay as normal wages or “regular pay,” then withholding is based on your W-4. This means that it should match the tax rate that you normally pay on your salary or wages.
• If the employer provides severance pay as supplemental wages, then it’ll be taxed at a 22 percent rate. It remains steady regardless of whether the pay is spread out or given in a lump sum.
• If severance is paid as a lump sum, it appears to the IRS as a raise, which may raise your annual income and your tax rate. (However, some people prefer the lump sum because of how it impacts their eligibility for their state’s unemployment insurance.)

Depending on how you’re paid, receiving severance could push you into a higher tax bracket. Severance may also affect your tax credits and deductions come tax time. Though this may be an unpredictable time, the best way to understand your tax impact is to meet with a tax professional and plan ahead with a financial advisor.

What should you do with severance pay?

Whether or not you receive severance pay, creating a plan for covering your transition between jobs can help you stay on track for your long-term goals. In the short-term, you can use severance to keep your plan on track until you find a new job, or if you are able to quickly secure something new, you may find yourself with added funds coming in that can be applied to other savings goals.

Regardless of what happens after you lose your job, it’s important not to worry too much. A good financial plan can weather unexpected events—like a job loss—so if you’ve got a good plan in place, you’ll likely be just fine. A Northwestern Mutual financial advisor can work with you to create this plan and to check in on it when life takes an unplanned turn.

This publication is not intended as legal or tax advice. Financial Representatives do not render tax advice. Consult with a tax professional for tax advice that is specific to your situation.