Taxation of Severance Payments Upon Termination: A Comprehensive Guide from our lawyer team

Taxation of Severance Payments Upon Termination: A Comprehensive Guide from our lawyer team

The taxation of severance payments upon termination or other forms of ending an employment relationship is a key topic for both employees and employers. This guide provides an in-depth overview of the legal regulations, common tax pitfalls, and proven planning models to minimize tax burdens. Attorney Dimitrov and Attorney Filippatos are available for a free initial consultation on all questions regarding severance payments.

What is a severance payment, and how is it taxed?

A severance payment is a one-time compensation payment made by the employer to the employee. Its purpose is to offset the loss of employment and compensate for any disadvantages caused by the termination. Tax-wise, severance payments are generally considered income from non-self-employment (§ 19 Abs. 1 Nr. 1 of the German Income Tax Act (EStG)) and are thus subject to income tax.

However, the Income Tax Act (EStG) offers a tax relief option: the one-fifth rule (§ 34 Abs. 1 EStG). This rule aims to mitigate the progressive effect of income tax on one-time payments.

Requirements for the One-Fifth Rule

The application of the one-fifth rule requires the following conditions:

  1. The payment must be a one-time compensation payment.
  2. The payment must be based on a new legal basis, such as a social plan, a termination agreement, or a court settlement.
  3. The payment must be made in connection with the termination of the employment relationship.
  4. There must be a concentration of income, meaning the severance payment exceeds the income the employee would have earned by the end of the year without the termination.

Examples of eligible severance payments:

  • Payments to compensate for the loss of a job.
  • Lump-sum payments agreed upon in a social plan.

Not eligible for tax relief:

  • Payments for unused vacation days or Christmas bonuses.
  • Compensation for damages, e.g., for defamation.

Tax Calculation Using the One-Fifth Rule

The one-fifth rule is applied as follows:

  1. The severance payment is notionally divided into five equal parts.
  2. Income tax is calculated on one-fifth of the amount.
  3. The tax on the one-fifth is multiplied by five and added to the regular income tax liability.

Example:

  • Annual income: €40,000
  • Severance payment: €100,000
  • Tax on one-fifth (€20,000): €3,912
  • Tax on the severance payment: €3,912 × 5 = €19,560

Without the one-fifth rule, the tax on the total severance payment would be significantly higher.

Tax Optimization Models

1. Mannheim Model
This model involves depositing the severance payment into a special account that funds early retirement. Benefits:

  • No immediate taxation.
  • Avoidance of progressive tax disadvantages.
  • Social security contributions apply only at the time of retirement payouts.

2. „Escape Clause“
Severance payment disbursement is postponed to the following year, in which income is low or absent. This reduces the impact of progressive taxation.

3. Contribution to a Rürup Pension
Part of the severance payment is invested in a Rürup pension to lower the tax burden. Since 2023, 100% of contributions are tax-deductible (§ 10 Abs. 1 Nr. 2 EStG). Attorney Dimitrov is available for inquiries regarding Rürup pensions.

4. Contributions to the Statutory Pension Insurance
To avoid pension reductions, employees can use their severance payment to make contributions to the statutory pension insurance. 50% of these contributions are tax-free (§ 3 Nr. 28 EStG).

Common Tax Pitfalls and How to Avoid Them

  1. Installment Payments
    • If the severance payment is made in installments, the one-fifth rule often cannot be applied.
  2. Ignoring Church Tax
    • Church tax can significantly increase the tax burden. Proper planning can prevent unpleasant surprises.
  3. Severance Payment and Income from New Employment
    • Additional income in the same year can increase the tax progression and reduce the benefits of the one-fifth rule.

Concentration of Income

The requirement for concentration of income is often misjudged. It is crucial that the severance payment exceeds the income that would have been earned by the end of the year. Income from a new job in the same year can affect the tax relief.

Social Security Aspects

Severance payments are generally exempt from social security contributions. However, exceptions exist:

  • Payments into value-based accounts are subject to social security contributions at a later stage.
  • Contributions to pension insurance can be tax-free or tax-advantaged.

Practical Tax Planning Tips

  1. Determine the Payment Timing
    • Severance payments should be made in a year with low or no additional income.
  2. Use Social Plans
    • Social plans provide legal certainty and tax benefits.
  3. Seek Professional Advice
    • Tax advisors or attorneys specializing in tax law can help develop individualized solutions.

Conclusion

The taxation of severance payments is complex but offers many opportunities to reduce tax burdens. Timely planning and compliance with legal requirements are essential to maximizing the benefits of the one-fifth rule or other models.

Do you want to optimize your severance payment? Contact us for personalized advice. Our team is here to assist you with expertise and experience!