IRS Clear On Subject Of Severance Pay
My wife is about to be eliminated in her job because the job is being eliminated and sheís going to receive a 9-month pay settlement. Iím under the impression that there is a certain kind of account that she can put these funds in and she can defer the taxes on them until they are withdrawn on an interest only basis. Is that a possibility?
M. D., Indianapolis
The IRS is pretty clear on the subject of severance pay. Lump sum payments that are given as a settlement to someone who is leaving a job are subject to income tax in the year in which they are received. Your wife will see the amount she received included in full on her W-2 form in the year in which she receives the money.
It may be possible to defer taxes on some of the money if your wife is eligible to participate in a tax-deferred retirement plan, such as an IRA. If she qualifies for a traditional IRA account, she can contribute up to $2,000 (this is an annual contribution limit), which can then be deducted on your joint income tax return. If you both qualify for this type of an account, and both of you have income of at least $2,000 during the year, up to $4,000 ($2,000 each) may be contributed and used as a deduction on your tax return.
for tax-deferred contributions
The rules for whether or not you qualify for participation in this type of IRA account are dependent on whether or not you or your wife participates in a pension plan at work. Also, the higher your income, the less likely it is you will be able to take a deduction for such a contribution.
Assuming the two of you file a joint tax return, and if neither of you participates in a pension plan at work, you may take the full $2,000 deduction for your IRA contribution.
If you do not participate in a pension plan at work and your spouse does participate in a plan, you may take a deduction of up to $2,000 if your joint income doesnít exceed $160,000 (if your income is in the range of $150,000 to $160,000 your deduction will be somewhat less than the maximum allowed).
If you participate in a pension plan at work, whether or not your spouse participates in such a plan, your deduction is limited if your joint 1999 income exceeds $51,000, and there is no deduction allowed if your income exceeds $61,000.
The deduction for an IRA contribution, if you meet the qualifications mentioned above, is taken on page one of your 1040. You donít have to itemize your deductions on Schedule A to take this deduction.
Even if you donít qualify to take a deduction for an IRA contribution, you can still make a contribution to either a traditional IRA account or a Roth IRA. Your contribution will not be deductible, but the earnings on the amount you place in the account will accumulate without your having to pay tax currently.
In a traditional IRA account, the earnings are taxed when you withdraw the funds. In a Roth IRA account the earnings are tax-free. These rules assume that you meet the requirements that go along with either of these accounts, including your age at the time of withdrawal and the number of years the money is held in the account.
for deferring taxes
Another alternative, if your wife decides to begin working on a free-lance or contract basis, is that she can set up a different type of retirement fund, such as a Keogh plan, a Simple IRA, or a SEP IRA. These plans allow for larger amounts that can be contributed in a tax-deferred manner. If you think your wife might qualify for one of these plans, the two of you should speak with a financial advisor who can help you choose the best plan for you.
It is probable that most if not all of the money your wife receives will be taxable. She should be sure to verify with her employer that both federal and state income taxes will be withheld, so that you wonít be caught by surprise when it is time to file your income tax return.
If your wife takes another job soon after leaving this one, and her combined income from both jobs for the year 2000 exceeds $76,300, she will most likely find that too much Social Security tax has been withheld. This is not something that can be adjusted by her new employer. Instead, you will file for a refund of the excess tax on your 1040 for 2000. There is a line on the tax return designated for this purpose.
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