Why is severance pay taxed at a higher rate?

Severance pay is taxed at a higher rate due to several reasons, including tax withholding, the Federal Insurance Contributions Act (FICA), and the Alternative Minimum Tax (AMT). Here is a closer look at each of these reasons that contribute to severance pay being taxed at a higher rate:

• Tax Withholding

  Employers that hand out large lump sums of pay in the form of severance compensation are required to withhold taxes from that payment. It is treated as if the ex-employee receiving the severance pay had earned that same amount of money over a fiscal year. This results in a higher rate of tax for severance compensation than for regular salaries or wages.

• Federal Insurance Contributions Act (FICA)

  FICA taxes are the taxes that the federal government uses to fund both Social Security and Medicare. Employers must withhold these taxes from an employee's paycheck, and if severance pay comes in one large lump sum, the employer might have to withhold FICA taxes on that amount, increasing the tax rate of the severance pay.

• Alternative Minimum Tax (AMT)

  The Alternative Minimum Tax (AMT) is a separate tax system made to ensure that individuals earning high income must pay a minimum tax amount, regardless of any credits or deductions. Severance pay can sometimes push individuals into a higher-income tax bracket resulting in them having to pay the AMT via their severance compensation.