Tax tip: how to save your severance pay from the tax authorities

In Germany, employees are generally not entitled to severance pay

E very dismissal is usually a hard blow that is difficult for those affected to overcome. This year, this is likely to affect thousands of employees in the Federal Republic: According to a cross-sector survey by the Institute of German Business, around 28 percent of the 2,300 companies surveyed expect to have to cut jobs in 2013.

It hurts a little less for those affected if they are dismissed with a "golden handshake". However, the tax authorities are also pleased about a severance payment.

Because for tax purposes, they are not treated like a gift, which flows into the account without deductions, but like wages. "In the past, there were certain allowances. Since 2006, severance payments have been fully taxable and would have to be added to regular annual earnings when calculating income tax," explains Isabel Klocke, legal counsel at the Taxpayers’ Association of Germany.

Under certain circumstances, this could result in a higher tax rate and the company having to pay significantly more to the tax authorities than usual. For example, the income of a normal earner, who has a taxable annual income of 40.000 euros, by a severance payment of 40.000 is taxed at 33.54 percent instead of 23.76 percent.

Fifths rule can save taxes

"There is no getting around the fact that the severance pay is taxed in full. One can mitigate the tax burden somewhat, however, through the so-called quintuple regulation," says Michael Henn, President of the Association of German Labor Lawyers in Stuttgart.

If it is applied, the income tax is first calculated on the regular annual income. In this case, the severance pay is fictitiously distributed over five years, a fifth is added to the income and the tax is calculated on this again.

The difference between the two amounts is multiplied by five to give the severance tax sum, which is added to regular income tax. "Certainly a somewhat laborious way of calculating, and the savings are not really high, but it’s better than nothing," finds Henn.

In order to be allowed to "quintuple," certain conditions must be met. First and foremost, the compensation must exceed the income lost as a result of the termination by the end of the year and must accrue to the dismissed person within one calendar year.

"A small subsequent surcharge of around five percent of the total amount will be tolerated. Otherwise, severance payments can be divided into installments, but not paid out over several years if you want to benefit from the one-fifth rule," explains Vicky Johrden, a consultant at the German Tax Consultants Association.

Postponement to next year

For this reason, however, the possibility of a severance payment in "annual stages" should not be dismissed out of hand, as it can be a means of saving tax irrespective of the one-fifth rule: "The taxable sum remains the same here. However, as it is not paid out in one calculation period, but split, it has a lesser impact on taxes," explains Klocke.

Because the degree of taxation increases with income, and you might stay at a lower rate bracket by splitting. A thoroughly appealing effect – and the partial payment is also legal, as long as it only takes place over two calendar years and the payment dates are agreed with the employer before the severance payment is due.

Whether dividing or quintupling is more favorable for tax purposes depends on the individual case. Because not only the income of the tax periods and the amount of the severance payment, but many other factors play a role in making the right decision, it is best to consult a tax advisor.

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The same applies to a third option: shifting the entire compensation payment to the following year. "This is legally possible and can be a good idea in some cases," says Johrden. This is especially true if you expect to have less income in the coming year than in the current one, for example due to unemployment.

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