Tax on severance pay: 10 tips to reduce your tax burden

Employees in Germany often experience a rude awakening when they see how much tax is due on a severance payment. Income tax, solidarity surcharge and church tax together can easily consume around half of a severance, especially for long-serving employees. Unfortunately, your options to reduce your tax as an employee in Germany are very limited, but there are still a few effective levers. Our guide explains how the tax on severance pay works and how you can legally reduce it.

How severance payments are taxed

A severance payment is compensation that an employee receives as a financial cushion for the loss of their job. It is meant to offset the financial disadvantages caused by the termination. Severance payments arise, for example, when:

• The employer wants to avoid a dismissal protection claim,
• The parties agree on a severance in a termination agreement, or
• A settlement with a severance payment is reached in a dismissal protection lawsuit.

In practice, the severance is often also the price for an efficient and predictable termination of employment for the employer.

In many cases, it is worth challenging the dismissal itself, not just accepting the first offer on the table. German labour courts often take an employee-friendly view of dismissals and are prepared to award better severance deals. Especially if you react quickly and stay within the three week deadline for filing a claim. Getting help from a specialist employment lawyer early usually pays off, because of often stronger severance packages.

practical tip:
Many employees focus on negotiating a higher severance amount. In practice, the payout date can sometimes have a greater impact on the net amount received than negotiating a few thousand euros more.

Basic principles of taxation of severance payments

Although a severance is remuneration for several years, the legislator treats it as taxable income in the year of payout. As a rule, severance payments are fully subject to income tax and potentially to solidarity surcharge and church tax. That creates two main issues for employees:

Progression effect

Because Germany uses a progressive tax system, a large severance payment can push parts of your income into higher tax brackets.

Example:
An employee earning EUR 12,000 per month receives a severance payment of EUR 200,000 after a successful dismissal protection claim. Because the severance is paid in the same tax year as the salary, the total tax burden increases significantly. In practice, almost half of the severance may be lost to taxes if no tax planning is undertaken.

German specialties: Solidarity surcharge and church tax

Another “tax problem”: From certain income levels upward, you also pay solidarity surcharge. Many taxpayers no longer pay the “Soli” in normal years because they stay below the allowance. But a large severance can push their income above the thresholds. These are:

• 68,413 EUR for singles
• 136,826 EUR for married couples.

All of a sudden, you pay not only more income tax, but also solidarity surcharge!

And if you are a church member, “church tax” comes on top. In that case, you usually pay 8 or 9 percent church tax on your income tax. There is a possibility to apply for a (partial) waiver of church tax on severance payments. After all, severance qualifies as extraordinary income for church tax purposes as well. In practice, churches often grant around 50 percent relief on the church tax on severance. But this can have side effects on your tax return in the following year.

No social security contributions on severance pay

One positive aspect: in most cases, no social security contributions are due on severance payments. This usually applies to pension insurance, health insurance, long term care insurance and unemployment insurance. Severance pay is not treated as regular remuneration for social security purposes.¹

However, if you are “voluntarily insured” in health insurance or have a particular special arrangement, there can be exceptions. In those cases, you should always ask your health insurer or tax advisor how your severance will be treated.

10 tips to reduce tax on severance pay

The tax burden for employees in Germany is high, and levers to reduce tax on severance pay are few. But even as an employee you can take a number of practical steps to reduce the overall tax impact. Not every tip suits every life situation, though. The following tools are ways to improve your net income, but not all will apply in your individual case:

1. Use the one-fifth rule for severance payments

The first instrument is the one-fifth rule for certain types of “extraordinary income”. This includes severance payments.

In simple terms, the tax office calculates the tax as if you received one-fifth of the severance in each of five years. And then multiplies that tax by five. This often reduces the progression effect and, therefore, the tax on your severance pay. At least a bit!

The one-fifth rule does not change the fact that the severance is taxable. It simply lowers the average rate on this part of your income. In practice, the effect is strongest where regular income is relatively modest, and the severance amount is comparatively high. Where you already have a very high salary, the numerical benefit is often smaller than many people expect.

Example:
A single employee (no church tax) earns a salary of 60,000 euro and receives a severance of 40,000 euro, paid together with her December salary. The conditions for the one fifth rule are met. After deducting 10,000 euro in work related expenses and special expenses, her taxable income is 50,000 euro, and the one fifth rule is applied to the severance portion. The result is an income tax saving of around 600 euro compared to full taxation without the special rule. On top of that, solidarity surcharge drops out, which saves about 1,300 euro more. In total, the one fifth rule reduces the tax on the severance by roughly 1,900 euro in this example, useful but not spectacular.

Important change from 2025

From 2025 onward, the one-fifth rule will no longer be applied automatically in wage tax withholding. Now, the employer will withhold wage tax without using the one-fifth rule, even if it could reduce taxes. For employees, this is inconvenient. It is not necessarily a disadvantage, unless of course, you forget about it in your tax return. Important: You have to check the box to apply the one-fifth rule to your severance. But almost any tax software will ask you about it. It is hard to forget.

• Before you sign a severance agreement, run at least two simple scenarios:
  • One with the one-fifth rule – as described above.
  • One with an alternative payout pattern – which might not qualify for the one-fifth rule, but can reduce the progression effect by spreading payouts and therfore optimising timing of payout. See Section 2 below.
• Combine expected severance, your other income, and possible deductions.
• Then check which pattern leads to the lowest total tax in your situation. When in doubt, consider asking your tax advisor before you sign the agreement.

2. Optimise timing of payout

The second major lever is the timing of the payout. The key principle is simple: for tax purposes, what matters is when the money flows into your account. Employer and employee are free to agree on the payout date in the termination agreement or in a court settlement, and the Federal Fiscal Court has confirmed this for severance payments.

Therefore, it can be sensible to “spread the severance pay” over more than one year or to shift the entire payout to a year in which your other income is significantly lower. This can reduce the progression effect and, in turn, lower the tax on your severance pay. However, this must always be coordinated with the practical and legal realities of your case.

Before signing a severance agreement, calculate at least two scenarios:

• payment in the current tax year
• payment in the following tax year

The difference can amount to several thousand euros.

Option 1: Spread the severance over several instalments

Instead of relying purely on the one-fifth rule, you can reduce tax by structuring the severance as several instalments over different years. For example, if you negotiate your severance in December 2024 and know that you will take a career break in 2025, it can make sense to move the payout fully or partly into 2025. Then the tax on your severance pay is primarily calculated based on your lower income in that year.
Sometimes, it is even better to split the payment over two or more years, for example, by receiving part of the severance in January 2025 and another part in January 2026. This only helps if your other income in those years is low enough to keep the overall tax rate down. You should therefore always do the maths before you commit to any schedule.

Option 2: Shift the payout from December to January

Even a small shift in timing can help. A classic variant is to move the payout from December of the current year to January of the next year. This is entirely legal and has been approved by the Federal Fiscal Court. In practice, that simple shift can keep you below certain thresholds in the current year and give you more room for planning in the next year.²
If you want to use this option, the payout date must be clearly documented in the termination agreement or settlement. Otherwise, there is a risk that the payroll department will still process the severance in the old year.

Watch out: wage tax and liquidity

At the time of payout, you are often no longer employed by your former employer. An isolated severance payment without regular salary is frequently taxed under tax class VI in wage tax. Under tax class VI, very high amounts of wage tax can be withheld, and in many cases the one-fifth rule is not used at this stage.
This means that in the month of payout you may see up to about half of the gross severance go straight to the tax office, even if the final tax result after assessment should be lower. The overpaid wage tax can only be reclaimed in your income tax assessment, which can take months or more than a year. For your financial planning, you should therefore always look at both the final tax and your short-term liquidity.

3. Leaving church to avoid church tax

Your church membership has a direct effect on the tax on severance pay. If you are a member of a church that collects church tax, you pay an additional 8 or 9 percent church tax on the income tax due on your severance. For larger amounts, this can be a substantial figure.
For this reason, some employees choose to leave the church before a severance payout. This can indeed reduce the tax on your severance pay, but only if the exit is effective in the relevant period. In many federal states, the church exit must take place in the year before or at least well before the payout, otherwise church tax still applies for the year of the severance.

4. Applying for (partial) waiver of church tax

If you did not foresee the dismissal and have not left the church in time, there is still a little known tool to reduce church tax. Severance payments are extraordinary income not only from an income tax perspective, but also for church tax. In practice, it has become common for churches to grant a partial waiver of church tax on severance payments if you file a well reasoned application.

Typical practice is that roughly half of the church tax attributable to the severance is waived. There is no strict legal entitlement to this, but many congregations follow internal guidelines that allow this kind of relief. However, this waiver can reduce the amount of church tax that is deductible as a special expense, which may slightly increase your tax burden in the following year through a so called negative special expense.

5. Convert the severance into a company pension scheme

Another way to reduce tax on severance pay is to convert the severance, before tax, into contributions to a company pension scheme (bAV). The state supports such solutions when the employment ends through a special multiplication rule. Under this rule, contributions paid in connection with the termination of employment for retirement provision can be tax-free up to certain limits.

The tax-free maximum for contributions to pension funds and similar institutions is 4 percent of the annual contribution assessment ceiling in the statutory pension insurance (West), multiplied by the number of years you have worked for the employer, but capped at ten years. In suitable cases, this allows you to shift a substantial part of your severance into a pension product without immediate taxation, but you must, of course, consider the later taxation of pension payments and the investment quality of the product.

6. Increase work-related expenses in the payout year

You can also influence the tax on your severance pay through work related expenses. The basic idea is to pull forward planned purchases or training into the year of the payout. This increases your deductible expenses in the year with the high income and reduces your taxable base.

This is particularly useful for low-value assets such as office furniture, laptops, or professional literature, which can often be written off immediately up to a certain net amount. If you have negotiated paid garden leave as part of your severance, it can also make sense to invest in long-planned training courses while you are still formally employed, so that the costs count as work-related expenses.

7. Prepay private health insurance premiums

If you are privately insured or voluntarily insured in the statutory system, you can usually prepay your health insurance premiums for up to three years in advance. This does not change the only tax on severance pay itself, but it can optimise your use of the special expenses deduction. By loading more contributions into the payout year, you might free up room for other insurance contributions in subsequent years that would otherwise not be fully deductible.

Some private insurers also offer small discounts for prepayments. Compulsorily insured employees in statutory health insurance cannot normally use this tool, so you should first check your own insurance status.

8. Choose the right tax class for liquidity

The choice of tax class does not change the final tax on severance pay after assessment, but it affects your liquidity between payout and tax refund. Married couples in particular can sometimes improve their short-term net income by switching tax classes before the severance is paid.
The important point is that the tax office always recalculates the final tax based on your total annual income, regardless of the tax class used for wage tax. The tax class, therefore mainly controls the timing of tax payments, not the end result. Adjusting tax classes can still make sense if you want to reduce the initial shock on your net payout and avoid unnecessarily high wage tax in the short term.

9. Deduct legal fees as work related expenses

Many employees are surprised when they learn that, in a dismissal protection case in first instance, each side pays its own legal fees, even if the employee wins. But there is at least one advantage: legal fees directly connected to a dismissal protection claim can usually be deducted as work related expenses. This reduces your taxable income and indirectly reduces the tax on your severance pay.

You should therefore collect all invoices and receipts from your lawyer and from the labour court proceedings. In your tax return, list them as other work related expenses and clearly identify them as related to dismissal protection. Good documentation of emails, performance reviews, warnings and time sheets can not only help your lawyer in court, it can also support your position if the tax office asks questions about the nature of the expenses.

Tax tip:
Keep all invoices related to dismissal protection proceedings, severance negotiations and legal consultations. These costs may be deductible as work-related expenses.

10. Other ways to reduce tax on severance pay

Beyond the main tools, there are other ways to influence the tax on severance pay. In some cases, employees use Riester or other pension products to obtain additional tax deductions in the payout year. Others invest in structures that intentionally generate negative income in the short term, such as certain capital market products or property projects, in order to offset some of the severance.

These solutions are often complex and may carry significant investment risk. For employees who do not want to bear the cost risk of a court case alone, there are also success-based fee models and other arrangements where the lawyer only gets a higher fee if the result is clearly better. Such models can sometimes make it easier to enforce your rights without upfront legal costs, but the detailed terms should always be checked carefully.

Bigger picture: severance and tax planning

When you plan around the tax on severance pay, you should not look at the tax reduction in isolation. The decisive factor is how much money you have left after tax, after legal costs (and after any investments). For larger severances, it often makes sense to treat the whole topic as part of your long-term financial planning.

This includes the negotiation of the severance amount itself, the timing and structure of the payout, your expected income in the coming years and your personal plans. If you are considering a sabbatical, early retirement, self employment or partial retirement, the right structure for your severance can look very different. Many employees also underestimate how much their pension situation, existing company pensions and planned unemployment benefits should influence the ideal severance structure.

Must-have steps before a termination agreement

Before you sign a termination agreement or court settlement, take three concrete steps: first, gather all relevant documents such as your contract, salary slips and emails related to the termination. Second, check the three week deadline for filing a dismissal protection claim and do not let it pass if the dismissal seems questionable. Third, schedule a short consultation with an employment lawyer and a tax advisor to align severance amount, payout timing and your long-term plans so that you maximise your net result instead of just looking at the gross figure.

Tax-Optimised Investing of Your Severance

Once the severance has been paid, many employees ask how the remaining funds should be invested. While certain investments can offer tax advantages, tax savings alone should never determine an investment decision. A poor investment remains a poor investment, even if it generates tax deductions.

Property Investments

Property investments can offer tax benefits, particularly where depreciation allowances are available. Listed buildings may provide additional deductions for renovation costs.

However, tax benefits should be weighed against the underlying investment risks, including purchase price, financing costs, location and future rental prospects.

Paying Down Existing Debt

For many employees, using part of the severance to reduce existing mortgage debt can be an attractive option.

While this does not directly reduce income tax, it lowers future interest costs and improves long-term financial stability. The benefit is generally greatest where loan interest rates are significantly higher than the expected return from low-risk investments.

Asset-Holding GmbH or UG

Employees receiving larger severance payments sometimes consider investing through an asset-holding GmbH or UG. Such structures can offer tax advantages for future investment income.

However, they involve ongoing administrative costs and should usually only be considered for substantial investment portfolios. Professional tax advice is strongly recommended before establishing such a structure.

Practical Tip

Before investing your severance payment, consider:

• Your expected income over the next few years
• Existing debts and financing obligations
• Retirement planning objectives
• Tax implications of different investment structures

In many cases, preserving liquidity and financial flexibility is more valuable than pursuing aggressive tax-saving strategies.

FAQs on tax and severance pay

1. Section 14 SGB IV. Definition of remuneration for social security purposes, which usually excludes genuine severance payments ↩︎
2. BFH 11.11.2009, IX R 1/09; Federal Fiscal Court on the timing of severance payments ↩︎