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How to Reduce Income Taxes on a Severance Package

Written by Ed Snyder on .

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Business and industries are constantly under pressure from many different directions – shareholders, government agencies, consumers and competitors. In reaction to these pressures and in preparation for the future continued success of the business, many times companies lay people off. Among those companies recently is Eli Lilly. Unfortunately, these are the pressures of business, especially in a highly-competitive and rapidly changing industry like pharmaceuticals.

A severance package is offered to help bridge the gap between employment or into retirement. The severance benefit offered to employees has generally been from 3 months to 18 month's compensation based on the employee's years of service and it's paid out in a lump sum. That means you get one check with the entire amount. The lump sum is subject to ordinary income tax. With a large amount of money like this received in one year, especially if combined with other income earned during the year, you can easily find yourself in a higher tax bracket as a result of the severance payment. Even though income tax is withheld from your severance check, it may not be enough to cover the full tax liability on the lump sum.

One of the most frequent questions we get about severance payments is related to income taxes. Lilly employees want to know how they can reduce the amount of income taxes they will owe on the severance they receive. There really isn't anything you can do about reducing the income taxes that will be due on the severance itself, but there are a few ways you may be able to reduce income taxes for the year you will receive your severance payment.

#1: 401(k)

Although you cannot defer any of the lump sum into your 401(k), you can make adjustments while you're still employed at Lilly to defer as much of your income as possible to your 401(k) prior to exiting the company. Your 401(k) contributions are made on a pre-tax basis, meaning that amounts contributed are not included in your taxable income.

For example, let's assume your separation date is March 31, 2017, and there are four more pay periods before your separation date. Let's also assume that you have already contributed $1,500 to your 401(k) for the year (through February 10, 2017). To get the IRS maximum allowed contribution of $18,000 into your 401(k) for the year you will need to adjust your 401(k) contribution percentage so that $4,125 per pay period is deferred into your 401(k). If you are age 50 or older you can also make a catch-up contribution of $6,000 for a total of $24,000. So let's say that you are age 50 or older and you've already contributed $2,000 for the year. With four pay periods left before separation you will need to contribute $5,500 per pay period to defer the remaining $22,000.

Given the short time period to defer this amount of money, many won't be able to defer the IRS maximum for 2017 before their separation. It will be wise though to defer as much as you can. The Lilly 401(k) rules allow you to set your contribution percentage as high as 50% of eligible base pay per pay period, up to the IRS limit.

If you are making Roth contributions, those are made after-tax. It would be a good idea to change those contributions to pre-tax with the goal of helping to reduce taxable income for the current year because of the large lump sum severance payment.

You can make any of these changes on the Lilly Benefits Center website.

#2: HEALTH SAVINGS ACCOUNT (HSA)

If you participate in the Health Savings Account (HSA) through your medical benefits at Lilly you can use this to help defer more income from taxes. Let's use another example. Let's assume that you have health insurance coverage for you and your family and you are using the HSA. The maximum amount you can contribute is $6,750 for 2017. Lilly makes a contribution to your HSA of $1,600 per year which counts towards this maximum. We will assume the same March 31, 2017 separation date as the 401(k) example, and say that you have deferred $429.17 into your HSA so far this year (through February 10, 2017). Lilly's contribution to your account will be $1,600. If your maximum is $6,750 and you have contributed $429.17 and Lilly contributes $1,600, you will need to contribute $1,180.21 per pay period to reach the maximum contribution before exiting Lilly. You can make this contribution adjustment at mybenefitwallet.com.

If you're not able to get the maximum in your HSA by way of payroll contributions prior to leaving Lilly, you can do non-payroll, after-tax contributions after you have left as long as you remain on a high deductible health plan. You could do this by continuation of your current Lilly health insurance coverage under COBRA or if you move to a spouse's high deductible health plan. You will then deduct the amount of your non-payroll, after-tax contribution on your 2017 income tax return.

If you do not remain on a high deductible health plan you can still make a pro-rated HSA contribution based on the number of months that you were eligible. In our case above you were eligible for three months.

If your health plan is for yourself only and not family, your maximum HSA contribution for a full year is $3,400 and Lilly's contribution is $800. If you are age 55 or older you can also make a catch up contribution of an additional $1,000 on either the self-only plan or family plan.

If you did not defer the maximum contribution to your Health Savings Account for 2016, you have until April 15, 2017 to do so. You can make this contribution even if you make it after you separate from Lilly and are not participating in a high deductible health plan because the contribution is for a period when you were eligible. Although this doesn't help with your 2017 income taxes, which is the year you are receiving the lump sum severance, it does help to reduce 2016 income taxes, which keeps more money in your pocket and that's a good thing no matter what year it is.

To make non-payroll HSA contributions you can go to mybenefitwallet.com

#3: 529 COLLEGE SAVINGS PLAN

A 529 plan is a tax-advantaged plan designed to accumulate savings for future college expenses. These plans are sponsored by states, state agencies, or educational institutions. Many states offer state income tax deductions or tax credits for contributions to their plan. For most plans you must participate in the plan offered by the state you live in to get the tax deduction or credit. There are a few states that allow residents to deduct contributions to any 529 plan from state income taxes.

In Indiana, residents who contribute to the CollegeChoice 529 receive a state income tax credit of 20% up to a maximum of $1,000 credit per year. That means you can put $5,000 into the plan and receive a $1,000 tax credit. A credit is more valuable than a deduction, as it comes right off the amount of tax you owe instead of reducing the amount of money you owe tax on.

Let's look at a simplified example: We will assume your taxable income is $100,000 and your state and local income tax rate is 5%. You will owe $5,000 in state and local income tax. Now let's assume that you receive a $1,000 tax deduction. This means you can deduct $1,000 from your $100,000 taxable income. So after the deduction your taxable income is $99,000 and your tax owed at 5% will be $4,950. Your $1,000 tax deduction saved you $50.

If you receive a $1,000 tax credit, instead of a deduction, it means that you apply the credit to the amount of tax you owe. So you have $100,000 of taxable income and $5,000 in tax owed. You then apply the $1,000 credit to the $5,000 in tax owed, reducing the total tax owed to $4,000. From this example you can see that a credit is worth much more than a deduction. Currently Utah and Vermont are the only other states besides Indiana that offer a tax credit.

What if you don't have kids that you need to save for college for? You can open a 529 account for a grandchild, a niece or a nephew. If you're a Lilly employee residing in Indiana this is a terrific way to reduce your tax bill.

There aren't a lot of options for reducing the amount of taxes you will owe on your severance. We've attempted here to cover the most common ways to help reduce income taxes in the year you receive your severance payment. Depending on your specific situation, there may be other things that can be done to aid in reducing your taxes. Discussing your situation with a financial advisor and CPA would be a prudent start.

Oaktree Financial Advisors is neither endorsed by nor affiliated with Eli Lilly.

This article is not intended to give specific legal, accounting, or tax advice. You are urged to consult your professional advisors in these areas for assistance regarding your personal situation.

Information included in this material regarding Eli Lilly's retirement plan is based on sources such as the current Summary Plan Description.

Please keep in mind that while we do our best to keep this information up-to-date and accurate, it is subject to change. You should rely on the most recent information provided to you directly by Eli Lilly.

Photo credit: Paul Sableman