Does an employee have to pay tax on his severance pay if she/he loses her/his job? Unfortunately, in Germany: yes! Employees who receive a severance payment for the loss of their job have to pay tax on this income. However, there are ways to reduce your income tax 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?
Although a severance payment is paid as compensation for the loss of a job, it has been fully taxable in Germany for several years – i.e. the payment is subject to income tax. This is despite the fact that the severance payment as compensation for the loss of a job can reach a considerable amount and can therefore lead to a significant increase in tax progression in Germany. However, there is still a small tax concession via the “rule of fifths”. You can do a rough check of the range of a possible severance payment here:
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 is in our post on severance pay in general.
What is the going tax rate in Germany?
Income tax rates are progressive and up to 42%. However, the amount of tax on your severance pay depends heavily on your personal situation (and possibly that of your spouse or partner). We, therefore, recommend a discussion with your tax advisor or lawyer. However, you can get an initial indication with a free severance pay calculator. Calculate, for example, whether taxation with the rule of fifths is more favourable for you.
How can you optimize the tax on your severance payment?
It is a well-known fact that as an employee in Germany, there are very 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 it was paid out in one amount. In many cases, it would be more tax-efficient if the payout was in several installments. After all, the terminated employee has a lower income to pay tax in the following years – e.g. because there is still no new job – and thus a lower assessment basis. However, this is not possible with the rule of fifths.
Time distribution of payout
As an alternative to the “fifth rule”, taxpayers who are good at planning their income can reduce their tax burden by spreading the severance payment over several years – or simply not doing it! For example, if you can already foresee when negotiating the severance payment in December 2021 that you will take a break in 2022 – and will therefore have lower income – you can postpone the payment in whole or in part to the following year – and thus only pay tax on the severance payment in the following year.
A payment, for example, on February 1, 2022 instead of December 31, 2021 can significantly reduce the income tax on severance pay in Germany if the other income in 2022 is significantly lower than in 2021 and the income tax progression is therefore lower. In principle, the timing of the allocation depends on the inflow time! However, this always depends on the specific individual case (e.g. what other income is generated and what the overall tax burden is).
If you want to check the amount of your severance payment, you can do so here: