When the employment relationship ends, the employer may pay severance. What many do not know: You have to pay tax on this severance. In this article, I answer the most important questions about tax on severance.
- What is severance?
- How high is severance typically?
- Am I entitled to severance?
- Do I have to pay tax on my severance?
- What is the one-fifth rule?
- Does a specific arrangement regarding the payment date bring financial advantages?
- When does the one-fifth rule not apply?
- Where do I have to declare the severance in my tax return?
- Conclusion
1. What is severance?
Severance is a one-time special payment that the employer makes to you as an employee. As a rule, severance plays a role when the employer wishes to terminate the employment relationship. It usually has two purposes:
- On the one hand, it is intended to cushion the hardships of dismissal for you.
- On the other hand, the employer usually wants to use the severance to persuade you not to file an unfair dismissal claim against your termination. You often receive the severance only if you accept the dismissal definitively.
2. How high is severance typically?
There is no fixed amount for severance. The greatest influence is the negotiating skill of the parties. Therefore, it is important that you are represented by an experienced lawyer for employment law.
For an initial rough orientation, you can use this formula:
0.5 monthly salaries (gross) x number of years of employment
Example:
You were employed in the company for five years at a gross salary of €4,000. According to this formula, you can expect severance of €10,000.
If your employer’s severance offer is significantly lower, you may be able to negotiate a higher amount. However: The exact amount that is realistic depends on the circumstances of the individual case. A major influence is how well the employer can justify the dismissal. If the labor court would likely declare the termination invalid, you have chances of a lucrative severance that far exceeds the above formula. Even if the employer can cite good reasons for your dismissal, they are often still willing to pay at least a small severance to eliminate any risk.
3. Am I entitled to severance?
Many employees assume that they are entitled to severance in any case after leaving. However, that is not correct in this form. There is no general entitlement to severance after either a dismissal or a termination agreement. However, there are exceptions in certain situations:
- Before a large-scale job reduction, the employer and works council agree on a social plan. In this, the parties often also stipulate severance for departing employees.
- If the dismissal is unlawful but continued cooperation between the parties is no longer reasonable, the court can require the employer to pay severance.
- If a collective agreement applies to your employment relationship, it should be reviewed for possible provisions regarding severance. Collective agreements also occasionally provide for an entitlement to severance for departing employees.
- The same applies to employment contracts of senior executives.
- If you are fortunate, the employer will offer severance directly with the dismissal.
But be careful! Do not accept your employer’s severance offer without review. In many cases, a higher amount can be negotiated.
Even if there is no entitlement, you often still have good chances of receiving severance. The payment also makes sense for the employer. In particular, it avoids long and expensive proceedings with uncertain outcomes. During this time, your employer cannot adequately plan for the position and must pay you all outstanding wages if the dismissal was invalid. As an employee, you therefore have a good negotiating position if you offer not to file a claim or to drop a claim already filed.
4. Do I have to pay tax on my severance?
Until 2003, severance was tax-free, but since 2006 it has been subject to income tax.
This means a comparatively high tax burden for many employees. The higher the income, the higher the tax rate. The high one-time payment causes the taxable income in one year to rise rapidly. A higher tax rate therefore generally applies to your increased total income than to the income in previous years.
- The one-fifth rule can provide some relief in this respect (see below).
- Your employer generally handles the calculation and payment.
- Social security contributions do not apply to severance.
Caution: Social security contributions do become due to the extent that outstanding salary or your vacation compensation is hidden in your severance. This occurs if you agree with your employer that outstanding wage claims or your financial compensation for unused vacation are simply added to your severance.
5. What is the one-fifth rule?
The so-called one-fifth rule at least partially offsets the effect that the severance leads to a higher tax rate for you.
Severance payments are classified under tax law according to § 34 EStG as extraordinary income. The tax authorities basically apply to the entire severance the tax rate that would apply if your severance were only one-fifth of the actual payment.
In detail, the one-fifth rule works as follows:
- First, it is calculated how much tax you would pay in the relevant year without the severance.
- Now one-fifth of the severance is added to your regular annual income.
- Now it is calculated how much tax applies to this income.
- In the fourth step, the difference between the tax burden with and without the one-fifth of the severance is calculated.
- This amount is multiplied by 5 to obtain the total tax burden for your severance.
Example: A single employee has an annual income of €26,000 gross, on which income tax of €3,776 would be payable in 2022. However, he now receives severance of €10,000, one-fifth of which (i.e., €2,000) is added to the income. Income tax of €4,356 would be due on the resulting €28,000 for 2022. The difference between the tax burden without and with severance payment is therefore €580. This difference is then multiplied by five, making €2,900 income tax on the severance. For the entire year 2022, income tax of €3,776 + €2,900 = €6,676 is therefore due. Without the one-fifth rule, the tax burden would be €161 higher.
6. Does a specific arrangement regarding the payment date bring financial advantages?
Under certain circumstances, it may make sense to postpone the payment of the severance to the following calendar year. This makes sense if your income tax will be significantly lower in the coming year due to lower income (for example, because no new job is in sight).
If you already pay the top tax rate on your income (just barely) without severance, the one-fifth rule does not reduce the tax burden either. However, if you postpone the payment of the severance to the next calendar year through an appropriate agreement with the employer, in which you may receive unemployment benefit I, you generally pay a lower tax rate on the severance.
To achieve similar effects as with the one-fifth rule, you can also agree with your employer on an “installment” payment of your severance over several years. If you stretch the payment over more than five years, the savings effect is even greater. However, you then have two disadvantages:
- You cannot invest the money during this time and lose return income.
- If the company is closed in the meantime or slips into insolvency, you will no longer receive the outstanding installments (or at most fractions).
Alternatively, you can also pay your severance into occupational pension provision or the statutory pension. However, taxes are also due in this case. In addition, at least in the context of occupational pension provision, social security contributions also become due.
7. When does the one-fifth rule not apply?
The one-fifth rule only applies if the severance is paid out in one year either all at once or in several installments. However, if you receive more than ten percent of the severance only in the following year, the one-fifth rule is not applicable and the tax burden is correspondingly higher.
In addition, your income must be concentrated within the calendar year, i.e., be higher than before. This means that the severance and other income flowing from the contract termination until the end of the year must be higher than the wages that would have accrued until the end of the year without the termination. If you are dismissed at the very beginning of the year and subsequently receive unemployment benefit I, this requirement is often not met. However, since your income is lower over the year anyway, you do not jump into a higher tax bracket due to the severance.
8. Where do I have to declare the severance in my tax return?
The severance must be declared in the tax return in Annex N if the one-fifth rule applies. If this is exceptionally not the case, the severance must be declared in line 18,
the wage tax and solidarity surcharge due on it in line 19 and the church tax in line 20.
9. Conclusion
- Employees generally have no entitlement to severance unless a special provision exists. Nevertheless, severance is frequently paid to avoid an unfair dismissal claim.
- The amount of severance results primarily from the negotiating skill of the parties. However, both employees and employers often have an interest in termination with severance payment.
- You have to pay tax on the severance. However, with the so-called one-fifth rule or certain arrangements, you can reduce the tax burden somewhat.
- The severance must be declared in Annex N of the tax return.