Understanding Severance Packages, Part 1: Severance and deferred compensation

Whether it comes after a year, a decade or a whole career, being dismissed from your job is never easy. Routines are upended, relationships are disrupted, and your sense of identity may take a hit. Your next step could be a job in the same field, a new career path, an entrepreneurial project or perhaps even retirement. But while you think it over, you’ll also have some important financial issues to consider.

Welcome to the first article in a five-part series about severance-related issues that you should know about if you ever find yourself in this challenging position. Today, we will look at severance and deferred compensation.

How severance packages work

Severance is commonly paid in a lump sum a few weeks after your separation date but can also extend over a period of several weeks or months. Payment is subject to ordinary income tax, and typically, you can’t defer any of the payment to your 401(k) or deferred compensation accounts since the payment is made following your separation date.

Taxes will be withheld, as well as applicable state, FICA and Medicare tax. Since this severance payment could bump you into a higher tax bracket, it’s important to think about whether the standard 22% federal withholding tax is enough.¹ You might need to set aside extra cash from your payment to cover the full tax.

If you don’t need to use all of your severance payment for living expenses, we often find that such a severance “windfall” presents a good opportunity to tackle other goals like debt payments, college savings or replenishing an emergency fund.

Deferred compensation

If you were eligible for a deferred compensation plan, you may have used it to defer a large amount of your annual base salary and bonus each year. If you’ve accumulated significant assets this way, you’ll now want to understand the timing of distributions. Since this is a non-qualified retirement plan, assets can’t be rolled over to an IRA. Instead, they’re distributed to you.

Distributions from the plan will start within a specified period after your separation date and are made based on the schedule you selected each year during the enrollment period. Typical distribution options are to receive a lump sum or payments over a particular period. Since distributions are taxed as ordinary income, you could lose over 40% of your withdrawal to taxes, depending on the distribution amount and your other income sources in the year of distribution.

Potential ways to avoid having deferred compensation taxed at the highest bracket include accelerating or deferring other income to a future year, which could help reduce your level of taxation. If possible, consider grouping tax deductions into the year when you receive a large distribution.

Also think about creating a donor-advised fund to help minimize tax while supporting your preferred charitable causes. Through this strategy, you may gift assets—even several years’ worth—to the donor-advised fund and immediately receive the corresponding tax deduction while deferring any gifting to the charity until a later date that’s appropriate for you. It’s like getting an advance tax break on your future charitable giving.

If your deferred compensation balance will remain in its plan for several years, be sure to coordinate your investment allocation with your other investments and overall financial plan so that everything remains aligned with your risk tolerance and goals.

We’re here to help

Over the years, our team has helped many executives and professionals navigate the complicated and often overwhelming severance process. We’ll develop a personalized strategy, including investment recommendations, to help you make the most of your severance package and position your finances for long-term success.

Need support regarding your severance package and deferred compensation? Contact a Corient Wealth Advisor today.

Other topics in this series

• Part 2: 401(k)
• Part 3: Stock awards and your investment portfolio
• Part 4: Insurance
• Part 5: Pension plans

¹ https://www.empower.com/the-currency/work/bonus-tax-rate.

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