Federal law doesn't require an employer to give employees severance pay when they terminate — that's a matter between the employer and the employee. If an employer chooses to give severance, he may pay it as a lump-sum amount or over a series of regular payrolls. Severance is subject to certain payroll tax deductions and, depending on company policy, voluntary deductions. Keep all of these factors in mind when calculating severance net pay.
Determine the gross amount for severance — the amount you agreed to pay the employee before taking out deductions.
Subtract pretax deductions, such as a Section 125 medical plan, from gross severance, if applicable. The remainder is the taxable amount. This process varies by company. If payment is made in a lump sum, you may stop the employee’s benefits and pay severance with her final paycheck. If severance is made over a period of time, you may allow the employee to continue receiving benefits. If she has no pretax deductions, all of her gross severance is subject to taxation.
Deduct federal income tax according to the employee’s filing status and allowances that he claims on lines 3 and 5 of his W-4 form and the IRS Circular E tax-withholding table that matches that data plus his severance amount and pay period. Use this method if you're spreading out the payments over multiple payrolls. If you're making a lump-sum payment, which is paid at the same time as the employee’s final regular paycheck but on a separate paycheck, withhold federal income tax at a flat 25 percent.
Deduct wage garnishment, if applicable. Severance pay is considered wages and is, therefore, subject to garnishment.
Subtract post-tax voluntary deductions, such as a Roth 401k, if applicable. The remainder is the employee’s take-home pay.
Contact your state department of revenue for its procedures regarding state income tax withholding and severance pay. For example, Alabama provides an exemption from state income tax for employees who lose their jobs due to administrative downsizing — the first $25,000 of severance is exempt if the employer receives approval from the state department of revenue.
Contact the IRS to determine if you should withhold Social Security and Medicare taxes from severance.