Tax on severance pay

When an employee is dismissed, he or she often receives a severance payment. This is a one-off cash payment arranged by the employer due to the termination of the employment relationship. The severance payment is intended to compensate the employee for the termination.

It should be noted that the severance pay must also be taxed and declared in the tax return.

Paying tax on severance pay

In principle, severance pay has been a normal income since 2006. Since then, severance payments are no longer completely tax-free. Such payments do not have to be taxed only if the total income for the year including the severance payment does not exceed the basic allowance (10,908 euros for 2023).

– One already receives notice for the end of January. The gross salary for this month was 2130 euros. In addition, there is a severance payment of 5999 euros.

In the above example, the tax-free amount was not exceeded: Consequently, the payment is exempt from tax. The example also illustrates well that in many cases it can be worthwhile to accept a lower payment in order to book a financial gain through tax in the end.

The severance payment is always added to all other income that the taxpayer must declare in the income tax return. If the entire income with the severance payment exceeds the limit of the basic tax-free amount, the rule of one-fifth is applied.

– There are always curious cases and court rulings. For example, there was an employer who documented the toilet visits of his employee. Over a period of 2 weeks, he came up with 385 minutes that the employee was supposed to have spent on the toilet. As a result, the boss cut his salary by 680 euros. The court ruled in favour of the employee because he suffered from digestive problems (AG Köln, ref.: 6 Ca 3846/09).

The one-fifth rule

The tax on a corresponding compensation payment is calculated using the so-called rule of fifths.

– Paul is dismissed and receives a severance payment of 10,000 euros. Until the termination he has earned a total taxable income of 40,000 Euros.

The severance payment is now calculated in several steps:

1. the income that Paul has to pay tax on is made up of the income of 40,000 and one fifth of the severance payment:

40,000 euros

– 20% of 10,000 euros (2,000 euros)

= 42,000 euros

The income tax to be paid here amounts to:

9,280.00 euros

In the next step, the taxable income must be calculated without the severance pay:

Income tax of 40,000 euros

= 8,569.00 euros

3. in the third step, the difference between the income tax with and without the severance pay is calculated:

9,280.00 euros

– 8.569,00 Euro

=711 Euro

Finally, the difference must be multiplied by five. This result (711×5=3,555.00 euros) is then added to the income tax that would be payable without the severance pay.

8,569.00 euros

– 3,555.00 euros

= 12,124.00 euros

– 12,124.00 euros is the income tax Paul has to pay on the severance payment and his income with the one-fifth rule.

In comparison, without applying the rule of fifths, the total income tax would be 12,971.22 euros. In this case, the severance payment of 10,000 euros would be added to the total income (40,000 euros) to determine the income tax. Using the rule of fifths, Paul makes a saving of 827.22 euros.

Declare severance pay in the tax return

The severance payment is recorded in the income tax return under Annex N. The severance payment should also be included in the tax return. The severance agreement drawn up with the former employer should also be submitted with the tax return. A note to this effect can be found under item 17 „Compensation“ of Annex N.

Incidentally, the employer pays the tax to be paid. As a rule, the employer checks whether the one-fifth rule can be applied to the severance pay. If the employer fails to do so, the tax office will check whether the taxes for the severance pay have been calculated correctly after the tax return has been submitted.