Sep 1, 2022
Understanding severance packages (Part 1 of 5)
Part 1: Severance and deferred compensation
Whether you’ve been at your place of employment for one year, one decade or your entire career, being dismissed from your job is never easy.
Aside from the emotional aspects of upending your daily routine and leaving colleagues you’ve become close to, your sense of identity may also take a jolt as people are often defined – rightly or otherwise – by what they do for a living.
As you weigh your options for next steps, such as finding another job in your field, trying a new career path, starting your own business, or retirement, there are important financial considerations related to being let go.
In our five-part series on severance-related issues, we’ll explore several key areas pertaining to your finances that you should know about, in case you find yourself in this challenging position.
In this article, we discuss 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. You might need to set aside extra cash from your payment to cover the full tax.
If you can save your severance payment and invest for the future, consider whether you should keep the proceeds handy until you know your cash flow needs. We often find such a “windfall” presents a good opportunity to tackle other goals like debt payments, college savings or emergency-fund replenishment.
If you’re eligible to participate in this non-qualified retirement plan, you likely had the option to defer a large amount of your annual base salary and bonus each year. If you’ve accumulated significant assets in the deferred compensation plan, you’ll 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 time 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, and periodically rebalance the account to keep it aligned with your chosen overall investment allocations.
We’re here to help
Over the years, our team has helped many corporate executives and professionals make decisions about their severance and navigate this complicated, often overwhelming 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 CI Private Wealth advisor today.
Other topics in this series
- Stock awards and your investment portfolio
- Pension plans
ABOUT THE AUTHOR
Lisa is a Partner and Wealth Advisor at CI Brightworth and has served as chairwoman of CIPW’s Business Development Committee. In addition to working with clients, Lisa has published three books, Girl Talk, Money Talk. The Smart Girl’s Guide to Money After College; Girl Talk, Money Talk II. Financially Fit and Fabulous in Your 40s and 50s; and CI Brightworth’s first book, Building Your Wealth Inside Corporate America. Lisa has been featured in The New York Times, The Wall Street Journal, YahooFinance, CNBC.com, and many more, and frequently speaks at seminars across the country.
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