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You've been offered a severance package—perhaps from a layoff, an early retirement incentive, or a negotiated departure. The lump sum looks substantial, and you're weighing your options during an already stressful time. How you handle this money could significantly impact your financial security for years to come.
Here's what you should do with a large severance package.
Understand What You're Actually Receiving
Before making any decisions, clarify exactly what your severance package includes. Severance isn't always straightforward—it often consists of multiple components, each with different tax treatment and timing.
Your package might include:
Cash severance payments based on years of service or negotiated terms
Accrued paid time off or unused vacation days
Bonus payments either prorated or full depending on departure timing
Stock options or restricted stock that may vest immediately upon termination or be forfeited
Retirement plan contributions including any employer matching or profit-sharing that wasn't yet vested
Continued health insurance through COBRA or company-subsidized coverage for a specified period
Outplacement services providing career counseling and job search support
Non-compete or non-solicitation provisions that might limit your future employment options
Get everything in writing. Review your severance agreement carefully—ideally with an employment attorney—before signing. Once you accept, you typically waive your right to sue for wrongful termination or other employment-related claims.
The Tax Hit You Need to Anticipate
Severance payments are taxed as ordinary income, and they can create a significant tax burden. Unlike retirement plan distributions where you might have some control over timing, severance typically arrives all at once in the year you receive it.
If you earned $80,000 in salary during the year and receive $100,000 in severance, your taxable income jumps to $180,000 for that year. This pushes you into higher federal tax brackets and may trigger additional state taxes and Medicare surtaxes.
Your employer is required to withhold taxes from severance payments, but the withholding rate may not be sufficient to cover your full tax obligation—especially if the severance pushes you into higher brackets than your regular withholding anticipated.
Calculate your likely tax bill with a CPA before spending your severance. You may need to set aside 30-45% for federal and state taxes depending on your situation. Failing to account for taxes leads to unpleasant surprises when you file your return.
Consider making estimated tax payments if your withholding is insufficient. Missing estimated tax payments triggers penalties and interest that add to your burden.
Address Immediate Cash Flow Needs
Your first priority is ensuring you can cover essential expenses during your job transition. Most people take longer to find new employment than they expect, especially for professional roles.
Calculate your monthly expenses—mortgage or rent, utilities, insurance, food, transportation, minimum debt payments. How long can your severance sustain you?
Build an adequate cash reserve before considering other uses for your severance. Financial planners typically recommend 6-12 months of expenses for job-seekers, more if you're in a specialized field or if economic conditions are challenging.
Park this reserve in a high-yield savings account or money market fund where it remains accessible without risk. You need certainty about this money—market volatility isn't acceptable when you're depending on these funds for essentials.
If your severance is insufficient to cover a full year of expenses, prioritize building this cushion over any other financial goals. Your immediate stability comes first.
Make Smart Debt Decisions
Severance creates an opportunity to eliminate high-interest debt, but you need to balance debt payoff against maintaining adequate liquidity during unemployment.
Prioritize high-interest consumer debt like credit cards or personal loans above 8-10% if you still have adequate cash reserves after paying them off. The guaranteed return of eliminating these debts often exceeds what you can reliably earn elsewhere.
Be more cautious about low-interest debt like mortgages or student loans. If your mortgage is at 3-4%, keeping it while maintaining larger cash reserves during job search might make more sense than paying it off and limiting your liquidity.
Never drain your reserves entirely to become debt-free. You need accessible cash during unemployment more than you need to eliminate low-rate debt.
Handle Health Insurance Immediately
Losing employer-sponsored health insurance is often the most pressing concern after job loss. You have several options, each with different costs and coverage:
COBRA continuation coverage allows you to keep your employer's health plan for up to 18 months, but you'll pay the full premium plus a 2% administrative fee. COBRA is expensive—often $600-2,000+ monthly for family coverage—but it provides continuity of care and protects pre-existing condition coverage.
Healthcare marketplace plans through the Affordable Care Act may cost less than COBRA, especially if your reduced income qualifies you for premium subsidies. However, you'll have a new network of providers and plan structure.
Spousal coverage if your partner has employer insurance and you're eligible to join their plan mid-year after losing your own coverage.
Don't go without health insurance. A single serious medical event could wipe out your severance and more. Factor health insurance premiums into your monthly expense calculation.
Retirement Account Decisions
If your severance includes retirement plan assets or if you have a 401(k) from your former employer, you'll need to decide what to do with these funds.
Rolling over to an IRA is usually the best option. This preserves tax-deferred growth, expands your investment options beyond what your employer plan offered, and consolidates accounts for easier management.
Leaving money in your former employer's plan is possible if your balance exceeds $5,000, but you lose the ability to contribute and may have limited investment options or higher fees.
Taking a lump sum distribution triggers immediate taxes and penalties if you're under 59½ (with limited exceptions). This should generally be avoided unless you're facing genuine financial crisis and have exhausted all other options.
Execute rollovers carefully. Use direct trustee-to-trustee transfers to avoid mandatory 20% withholding and 60-day rollover deadlines that create complications.
Strategic Investing of Excess Severance
Once you've secured adequate cash reserves, paid off high-interest debt, and addressed insurance needs, you can consider investing any remaining severance for long-term growth.
Don't rush to invest everything immediately. Markets will be there when you're ready. If job search takes longer than expected, you may need to tap funds you thought were "extra."
If you do invest, maintain appropriate diversification. This isn't the time for concentrated stock positions, speculative investments, or high-fee products that salespeople might pitch. Low-cost, diversified index funds typically serve job-seekers well.
Consider tax-advantaged accounts if you have earned income during the year. You might be able to fund a traditional or Roth IRA, contributing up to $7,000 if you're under 50, or $8,000 if you're 50 or older (2024 limits).
Plan for the Income Gap
Until you secure new employment, your severance needs to bridge the income gap. Create a realistic budget that distinguishes between essential and discretionary expenses.
Cut non-essential spending during job search. Subscription services, dining out, entertainment, and lifestyle upgrades should be minimized until your income stabilizes.
Consider consulting or contract work to extend your severance further. Even part-time income can significantly lengthen your runway.
Understand unemployment benefits you may be eligible for. In some situations, severance affects unemployment eligibility or timing, while in others it doesn't. Check your state's rules.
Review your investment contributions. If you typically contribute to retirement accounts or investment accounts from your paycheck, pause those contributions during unemployment to preserve cash flow.
Avoid Emotional Spending
Job loss is stressful, and severance packages can create a false sense of security. Many people treat severance as "windfall money" and spend more freely than they should.
Don't make major purchases or lifestyle upgrades during job search. The new car, home renovation, or luxury vacation should wait until you've secured new employment and stabilized your income.
Watch out for justifications like "I deserve this after what the company did" or "I'll find a job quickly." Job searches often take 3-6 months or longer, especially for professional roles. What feels like plenty of money can disappear faster than you expect.
Your Next Steps
Handling a large severance package well requires balancing immediate needs with long-term planning. Understand the full package and tax implications. Build adequate cash reserves for extended job search. Address health insurance immediately. Make strategic debt decisions that maintain adequate liquidity. Handle retirement accounts thoughtfully. Invest excess conservatively only after securing your foundation. Plan realistically for the income gap. And avoid emotional spending driven by stress or false security.
Your severance package represents a bridge to your next opportunity. Manage it wisely, and you'll cross that bridge with financial security intact.
This information is for educational purposes only and should not be considered personalized financial, tax, or legal advice. Every severance situation is unique. Consult with qualified professionals before making major financial decisions about your severance package.
Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Great Valley Advisor Group, a registered investment advisor and separate entity from LPL Financial.
Chesapeake Financial Planners | 2402 Scotlon Ct, Forest Hill, MD 21050 | (410) 652-7868 | www.chesapeakefp.com