Severance pay – what should you do?

The economic situation in Germany is poor. The war with Iran has, for the time being, dashed hopes of an economic recovery this year. Staff cuts are currently on the rise, particularly in the manufacturing sector – often accompanied by severance payments. What may at first glance appear to the recipient to be a financial cushion can actually become a tax burden. This is because severance payments are generally treated as income in the year in which they are paid out and can significantly increase the tax rate on total income. Anyone who fails to take action risks handing over a substantial portion of the payment to the tax authorities.

However, this can be mitigated. In many cases, a severance payment can be classified for tax purposes as extraordinary income. In such cases, the so-called ‘one-fifth rule’ may apply. The principle behind this is that, for tax calculation purposes, the severance payment is treated as if it were spread over five years, even though it is actually received as a one-off payment. As a result, the tax rate does not rise as sharply and the tax burden is often significantly reduced. The ‘one-fifth rule’ does not apply automatically; you must apply for it in your tax return.

It may also be worth checking whether tax-deductible expenses can be specifically brought forward to the year in which the severance payment is received, thereby reducing your taxable income. Property owners, for example, can bring forward planned renovations or energy-efficiency improvements. Tradesmen’s services are tax-deductible: up to €6,000 in labour costs qualify for relief; 20 per cent of this – up to a maximum of €1,200 – is deducted directly from the tax liability. In addition, household-related services such as domestic cleaning can be taken into account to reduce tax liability.

Another option is to make additional contributions to a pension scheme or advance payments into health insurance. Contributions to the statutory pension scheme or to a certified basic pension, as well as health insurance, are tax-deductible as special expenses, subject to statutory maximum limits. This reduces the tax burden in the year the severance payment is received, whilst at the same time strengthening one’s own financial security in old age. Particularly in the case of large severance payments, it is worth looking into untapped pension planning opportunities.

In the case of very large one-off payments, investments may be a consideration. For taxpayers who are currently running a business or planning to do so, the investment allowance may be applicable in certain circumstances. This allows parts of planned investments – such as in a photovoltaic system forming part of business assets – to be claimed for tax purposes even before the purchase is made. This reduces taxable income in the year the severance payment is received, but also defers tax consequences to later years. Given the complexity of the rules, it is advisable to seek professional advice in this matter.

The timing of the payment can also have tax-saving implications. If it is likely that your income will be lower in the following year – for example, due to retirement or a sabbatical – it may be advantageous to defer receipt of the severance payment until the following year. However, such a deferral must be agreed with your employer in good time.

Which measures make sense depends on your personal circumstances. However, by planning ahead, you can significantly reduce the tax burden associated with a severance payment.