Receiving a severance payment after leaving the company is everyone’s dream. Entrepreneurs pay out a severance payment as compensation after a dismissal. But not everyone receives a severance pay out.
There is no basic entitlement to severance pay, but compensation is still paid out to avoid any court proceedings. However, what few people know is that severance pay is fully taxed.
In our comprehensive guide on taxing severance pay, we want to equip you with helpful knowledge on how severance pay is taxed. Furthermore, you will receive from us all the answers to the most frequently asked questions regarding the topic of severance pay tax, to inform you about an upcoming severance payment.
The most important in a nutshell
- Most entrepreneurs pay out a severance pay to terminated employees. Severance pay is also called compensation payment. However, according to the tax law, the payment is fully taxed.
- The higher the income, the higher the tax rate, which in turn has a negative effect on the severance pay. Therefore, a so-called quintile regulation is offered, which can reduce high taxes.
- The severance pay can be paid either as a whole amount or in installments. However, it is important that the installments are paid in the same year, otherwise the one-fifth rule loses its effect.
Background: What you should know about paying taxes on a severance package
Before you make any decisions regarding severance pay, there are a few things you should be aware of. Therefore, in the following sections we will explain to you all the important information about the taxation of the severance pay to help you make your decision.
What is severance pay?
Severance pay is a one-time special payment that the employer pays to the employee after a dismissal. The severance pay compensates the employee not only for the loss of his job, but also for the future loss of service.From the side of the employee, there is no legal right to a payment of the severance pay.
However, if the employee is dismissed for operational reasons, he or she can demand a severance payment. However, this is only possible if the dismissed person neglects the deadline of a dismissal protection action. Only then is the terminated worker entitled to a severance payment.
You must make sure that this option is stated in the termination letter. Only then are you entitled to severance pay according to the Dismissal Protection Act ( 1 ) .
Must the severance pay be taxed?
Severance pay is no longer tax-free. However, in 2006 it was decided that severance pay must be fully taxed. Severance pay is considered extraordinary income (§34 EStG) ( 2 ) , which must therefore also be declared in the tax return. Social security contributions such as pension, health, nursing care and unemployment insurance are not included in this calculation.
According to the tax law, severance pay is considered as extraordinary income, therefore it is fully taxed since 2006.
However, people who receive a higher income are confronted with higher taxes than those with a lower income. The increase of the personal tax rate is determined by the amount of your income.
This means that the higher the income, the higher the own taxes will be, which can negatively affect the severance pay. What can reduce the taxation, however, is the so-called quintile regulation. It is currently the most authoritative and possible tax relief in this area.
What is a fifth?
This means that the total amount is fully taxed and only one fifth affects the tax rate. The one-fifth rule avoids a huge tax burden. People who have a high difference between the severance pay and the taxable income benefit the most ( 3 ) .
If the one-fifth rule is automatically applied?
This would mean that the employee himself must apply for the application of the one-fifth rule. What you have to keep in mind, regardless of the receipt of the tax allowance, is that the severance pay has to be declared separately on the tax return form.
How to calculate taxes according to the one-fifth rule? (Calculation example)
Here we show you an example of how the taxes are calculated according to the quintile rule:
Example: A single man is dismissed by his employer and receives a severance pay of 10.000 Euro. In 2020, after deducting all his deductible expenses (income-related expenses, special expenses and extraordinary burdens), he will otherwise have 42.000 euros as wages to be taxed.
For the quintuple rule, one fifth of the severance pay is added to it. The income tax due on this amount is compared with that due on the taxable income without severance pay. The fivefold difference of both amounts is considered as income tax for the severance pay.
|Annual income (after income-related expenses, etc.).)||€ 42.000,-|
|+ one fifth of the severance pay||€ 2.000,-|
|= Taxable income||€ 44.000,-|
|Income tax 2020 with severance pay||€ 9.877,-|
|Income tax 2020 without severance pay||€ 9.156,-|
|= differential amount||€ 721,-|
|Fivefold difference||€ 3.605,-|
|Taxes with quintuple regulation||€ 12.761,-|
|– Taxes without quintuple rule||€ 12.930,-|
|Tax saving||€ 169,-|
|Tax savings in percent||1,31 %|
With simple five steps we explain you how the results of the taxed severance pay:
- Step 1: First you have to calculate a fifth of your severance pay by dividing the amount of severance pay by a fifth. The result is added to the annual income, minus the income-related expenses, special expenses as well as extraordinary burdens. The result is the taxable income. (Example: 10.000 / 5 + 42.000 = 44.000) Furthermore, the income tax due is then calculated with the severance pay. In this example this amounts to € 9.877,-. It is also important to calculate the income tax without severance pay. In the example, the annual income of € 42.000,- an income tax of 9.156 Euro.
- Step 2: In the second step you have to calculate the difference amount. To do this, the income tax of the annual income with severance pay is subtracted from the income tax of the income without severance pay. (Example: 9.877 – 9.156 = 721) The result is then multiplied by five. This is how you get the income tax that is only due on the severance pay alone, the so-called fivefold differential amount. (Example: 721 x 5 = 3.605)
- Step 3: In the second step you have calculated the income tax only for the pure period. In the third step, the total income tax is calculated. The income tax for the annual income must be added here. The result shows the total tax liability. However, this tax is due if the five-percent rule is applied. (Example: 3.605 + 9.156 = 12.761)
- Step 4: In the fourth step you can check whether you have actually saved on taxes. You must calculate the tax liability that would have been incurred without the application of the one-fifth rule. To do this, you add the annual income to the total settlement amount. (example: 42.000 + 10.000 = 52.000) For this amount you have to calculate the income tax again. In the example case this amounts to 12.930 Euro.
- Step 5: In the last step, the results of the third and fourth steps are subtracted from each other. The result shows how much was actually saved by the one-fifth rule. (example: 12.930 – 12761 = 169) If the quintuple regulation was claimed, then the tax saving is € 169,-.
As already mentioned, the amount of the tax depends on the income. This means that the tax saving is not always the same amount. The higher the difference between the annual income and the severance pay, the higher the tax saving is.
What are the requirements for the one-fifth rule?
- Same calendar year: In order for the quintuple regulation to be used to reduce taxes, the entire settlement sum must be transferred to your account within one calendar year. If, however, part of the severance payment is not transferred until the following year, then the amount must not exceed five percent of the total amount. In this case, you should definitely pay attention to this, because the tax office could collect the requested quintuple regulation.
- Accumulation of income: The second condition is the accumulation of income. This is the case if the severance payment is higher than the remaining income for the rest of the calendar year. More precisely: previous income of the current calendar year + severance pay> Income of the current calendar year + missing income due to termination of employment.
Does the employer have to pay tax on the severance pay?
Where to enter the severance pay in the tax return?
When applying for the severance pay, it is necessary to fill in the tax return correctly. Therefore, the data of the severance pay must be entered in Annex N, in the line "reduced taxed compensation".
If the severance pay is not taxed in accordance with this, then the severance pay must be entered on line 18 of the tax return. The applicable wage tax and the solidarity surcharge belong in line 19 and the church tax in line 20. In addition to the tax return, the relevant documents such as the termination agreement and the severance agreement must not be missing when submitting the return.
Where can you get a tax reduction?
- Church tax
If you are a church member, you can get back half of the church tax already paid by means of the tax return. In this case, you only have to submit an informal application to the church tax office or the Protestant regional church and apply for partial remission of church tax. Church tax counts as a special tax, so a subsequent partial remission can help you pay back income tax and the solidarity surcharge ( 6 ) .
- Use of a company car or company apartment:
A reduction in tax can also be claimed if the employee uses the company car or a company apartment despite termination of employment. When receiving further benefits from the former employer, the former employee must pay full tax on their use.
If the severance pay is considered as compensation for lost income?
Most people are convinced that, for example, in the event of a transfer of an undertaking, a change of employment or a change of activity with the same employer, a severance payment is paid out.
However, these points are not subject to income tax law and cannot be compensated with a severance payment. The employee does not receive the severance payment until termination, because the terminated employee no longer receives a salary from this point onwards.
Severance pay can be regulated in the termination agreement between the employer and the employee. Therefore, it is important to read the contract thoroughly before signing it.
How can a severance pay be increased?
The amount of severance pay depends strongly on the respective industry. To increase the severance amount helps in most cases negotiating skills. With the right sense of negotiation and tactical skill, the severance amount can vary.
What to watch out for when paying severance pay in installments?
However, the severance payment in installments must be handled with caution. If the employee has applied for the quintuple regulation, then it is only valid if the severance pay is paid out in one calendar year.
However, if the severance pay is spread over several years, then the quintuple regulation expires and cannot be used. This would mean that instead of mitigation, the full tax has to be paid. However, it should be mentioned that there is an exception.
If the severance pay is not shifted more than ten percent from the actual payment amount to another calendar year, then the tax authorities are prepared to set a taxpayer-friendly ruling.
How is the settlement of a Riester small-amount pension handled??
Unlike severance pay in the event of dismissal, a maximum monthly payment limit is specified here. Here the amount of the monthly severance pay is one percent. Of course, the maximum limit increases with the years.
From a monthly Riester pension of 31.15 euros, this may be paid out immediately without any subsidy. Accordingly, this amount is only taxed at a reduced rate. According to estimates, the amount of severance pay may only be approximately 9.be 500 euros. As a Riester saver, you benefit from state allowances or high special expense deductions.
Normally, the severance pay is paid only from the age of 62 at the beginning of the payout period.
In the case of older contracts, the severance pay can be paid out as early as at the age of 60. start at the age of 50. After the severance pay starts with the beginning of the payment phase, you have your advantage by being allowed to keep the received tax benefits.
Another advantage is that if, for example, you receive your salary in the first half of the year and do not retire until the second half of the year, then you should definitely not have the Riester small-amount pension paid out until the following year. If your severance pay remains below the mentioned limit, then you are entitled to the quintuple regulation and the severance pay is taxed in a mitigated manner and your salary is no longer taxed.
With the Riester contract, you can decide whether the settlement should be paid out in small installments with the starting year or only in the following year. It is important that the severance pay, which is paid out in small-amount pensions, be entered in the tax return in Annex R ( 7 ) .
Can a severance payment be converted into a retirement provision ?
There is also the possibility to apply for early retirement at the age of 50 without any disadvantages. In this case the retirement can be compensated by contribution payments.
The employer can also support the dismissed employee by paying the pension insurance contributions.
The company pension is a special form of severance pay, because the first half of the amounts paid is exempt from tax and the second half, however, is taxable. The advantage here is that the taxed amount paid as compensation is only taxed to a lesser extent by means of the one-fifth rule ( 8 ) .
severance pay after dismissal is something that not every company pays. Severance pay is intended to pay the employee a compensation sum for leaving the company.
However, it should be noted here that due to the high sum also high taxes are incurred, because severance pay is fully taxed. However, the quintile regulation can reduce the high taxes and also refund some, such as church tax.
With the fifth rule you have to watch out, because if the severance pay is not paid in the same year the rule is invalid and until again obliged to pay the full tax.
The good thing about severance pay is that the amount is not prescribed by law. This in turn leaves plenty of room for negotiation. It’s up to you whether you opt for a full severance payment or one split into installments.
Image source: Bill Oxford / Unsplash
1. Becker, J.: Keyword: severance pay. In: Springer Gabler publishing house (Ed.): Gabler Business Dictionary 2021. Retrieved on 18.03.2021.
2. TAX NET.de. Extraordinary income and one-fifth rule. Retrieved on 18.03.2021.
3. German Handicraft Newspaper. Severance pay: How to mitigate the tax burden. Retrieved 18.03.2021.
4. Handelsblatt. How terminated employees can pay taxes on severance pay. Retrieved on 18.03.2021
5. e severance pay. Taxes on a severance payment. Retrieved on 18.03.2021
6. gssr. Severance pay and church tax. Retrieved on 18.03.2021
7. Mirror. How to keep as much of your Riester pension as possible. Retrieved 18.03.2021