How to save tax on severance pay in Germany

Do you have to pay tax on your severance pay if you lose your job? Unfortunately, in Germany, the answer is yes. This blog article explains why – and how much – tax you might have to pay if you receive a severance payment for the loss of your job. However, there are several ways to reduce the income tax burden on severance pay in Germany. And a small consolation: severance payments are generally exempt from social security.

Do you have to pay income tax on severance payments in Germany?

A severance payment is typically paid as compensation for the loss of a job. It is therefore a “one-off” payment and should be regarded as compensation for the (many) years of work on the job for which loss is compensated. However, since 2006, all severance payments are generally subject to income tax. This does not only increase the tax base but can also significantly increase the tax progression. In Germany, the tax rate depends on income and increases from 14% to up to 45%. Which can lead to an unfair tax disadvantage in the year of payout.

However, there is still a small tax concession via the “rule of fifths“, which we will explain below. You can use this rule to mitigate at least some adverse tax effects. In case you’re just looking for a quick check of the tax effect of your severance pay: You can check the tax on the severance payments with our tax calculator here (only in German):

So you have to pay tax on your severance pay. In most cases, however, social security contributions do not apply. This applies to pension and health insurance as well as long-term care and unemployment insurance (there are exceptions for people with voluntary health insurance). The following explanations therefore deal exclusively with the taxation of a severance payment. Everything you need to know about negotiating your severance pay can be found in our general blog post article on severance pay in Germany.

What is the going tax rate in Germany?

Income tax rates in Germany are progressive (14% to 45%). However, the tax on your severance pay depends heavily on your situation (and possibly that of your spouse or partner). We, therefore, recommend a discussion with your tax advisor or lawyer.

To make things a little more complicated, there is also a “Surcharge” on income tax (Solidaritätszuschlag, or Soli) for high incomes. Which goes on top of income tax (5,5%). Taxpayers who are members of a tax-collecting religious community (like the catholic church), pay an extra 8-9% of their income tax to the church or religious community to which they belong. Surcharge and “Church Tax” go on top of income tax. Cold comfort to taxpayers: At least there are no local or state income taxes levied in Germany on income from employment.

How can you optimize the income tax on severance pay in Germany?

It is a well-known fact that as an employee in Germany, there are few opportunities to improve your tax burden! In the case of severance payments, however, one can make use of the “fifth rule“. Or schedule the payment of the severance pay to lower the overall tax burden.

Tax relief with the “one-fifth rule”

The so-called “fifth rule” reduces the tax burden because income tax rates in Germany are “progressive”. Means: With increasing income, the tax rate also increases. Especially if an employee receives a high severance payment at the end of a long-term employment. Due to the so-called “fifth rule”, the tax spreads evenly over five years. The employer deducts the wage tax and uses this form of wage tax calculation if it results in a lower wage tax. Those taxpayers with relatively low earnings and high severance pay have the greatest tax-saving effect. However, the reduced tax rate on the severance payment is only possible if the payout is made in one amount. It might, however, be more tax-efficient if the payout is made in several installments:

Distribution of payout over 2 years

As an alternative to the “fifth rule”, taxpayers can reduce their tax burden by allocating the payments over time. In the settlement, you can agree to spread the payout of the severance payment over 2+ years. If you foresee, when negotiating a severance payment (in fall 2023), that you will take an “income break” in 2024. Then you know that you will have a lower income in 2024. By postponing the severance pay in whole or in part to 2024, the tax progression in 2023-24 will be moderate. This is due to the fact that the determining factor for the “tax man” is the cash flow of the severance pay. And not the date of a termination or settlement. However, this depends on your case (e.g., what other income is generated and your overall tax burden).

Church tax

In Germany, you have to pay “church tax” on the severance payment, if you are a member of one of the churches. But there is a little-known “workaround” to at least reduce this tax. As a rule, church members can reclaim half of the church tax paid on a severance payment. Because the severance payment is also treated as extraordinary income for church tax purposes. You can therefore apply with the aim of partially “waiving” the church tax. This usually works for most church members, although there is no legal entitlement to such a partial waiver. However, for decades church members have been “waived” up to 50% of the church tax on them in such cases. Please note that the waiver has a countering effect of increasing income taxes since the church tax is partly eliminated, which in turn is fully deductible as special expenses. However, the net effect is positive, albeit smaller than one would expect.