severance payment

Your spouse should likely choose the 12-month payment stream to avoid a massive, unnecessary tax hit, and he will not owe Pennsylvania state tax on it due to the tax reciprocity agreement between Pennsylvania and Maryland.

Because Maryland and Pennsylvania share a reciprocal tax agreement, compensation (including severance) earned from PA services by a full-time Maryland resident is taxable only in Maryland. It does not matter whether he receives it as a lump sum or monthly payments, or that he no longer works there; he is exempt from PA state income tax. He should ensure his employer has Maryland Form MW507 and PA Form REV-419 on file to prevent incorrect PA tax withholding.

For a  severance payment when receiving a large sum there are significant tax implications to consider and the impact of either taxing as a lump sum or spread out over time.

Lump Sum or Installments

Receiving a single amount can create a significant increase in your total taxable income in a year and create a tax bracket spike increasing your overall tax rate into a significantly higher federal tax bracket.  It is important to look at the full picture, other items to look at would be if you are at retirement age with payouts and distributions or if there is closely held company stock with requirements of disposal when exiting the company.

There is the risk of under withholding  IRS rules default to a flat 22% federal supplemental withholding rate on lump-sum severance payments. If your household’s marginal federal tax bracket is 24%, 32%, or higher, the initial tax withheld will not be enough, leading to a surprise tax bill or potential underpayment penalty at tax time.  If taking a lump sum, evaluating if an increase in tax brackets would indicate that you request additional withholding or making an estimated tax payment(s) to avoid any underpayment penalties.

Receiving a lump sum does provide some opportunity to pay off debt that you could be carrying especially if it is high interest, possibly making the maximum amount of retirement contributions or investing the money sooner

If you receive installments (Spanning more than one year) It will provide for some tax bracket leveling. Payments spanning across over years (example, late this year into next year), the income is split across two tax filings. This will lower your taxable income each year, potentially preserving lower marginal rates and eligibility for income-based tax credits/deductions.

Receiving installments will aid in the withholding. Payments distributed through regular payroll are subject to standard W-4 withholding calculations rather than the flat supplemental rate.
 

There is the possibility of credit risk. A person would remain an unsecured creditor of the company over the extended period. If the employer encounters financial distress or bankruptcy, future payments could be delayed or lost.

If After leaving the company, you start to collect retirement benefits, a larger amount could be taxed and at a higher overall tax rate.

State Taxation: PA vs. MD Residency Rules

The PA-MD Reciprocal Agreement

Maryland and Pennsylvania share a Reciprocal Tax Agreement. Under this agreement, wage and compensation income earned by a Maryland resident from a Pennsylvania employer is taxable only by Maryland. Severance pay is treated as employee compensation under both states' tax codes.

Here are the steps to address the Payroll Withholding issue

Form REV-419: Ensure he submits PA Form REV-419 (Employee's Nonwithholding Application Certificate) to his employer's HR or payroll department. This certifies his Maryland residency so the employer does not withhold PA state income tax.

Maryland Tax Withholding: Request that the employer withhold Maryland state income tax instead. If the employer cannot set up Maryland withholding, he may need to make quarterly estimated tax payments to Maryland to avoid interest penalties.

If PA Tax Is Accidentally Withheld: If the employer erroneously withholds PA state tax from the severance, he will file a PA Non-Resident Tax Return (Form PA-40) showing $0 PA-taxable income to receive a 100% refund of the PA tax withheld.

In addition to the State taxes the consideration of the PA local taxes.  While state tax is exempt under reciprocity, local earned income taxes (EIT) in certain PA municipalities do not fall under reciprocal agreements. If his former physical workplace was in a PA locality with a local tax, a local tax credit may apply on his MD state return.

Helpful Links:
https://www.pa.gov/agencies/revenue/resources/tax-types-and-information/personal-income-tax/determining-residency#accordion-46f76b3846-item-23a4a7528b

https://www.marylandcomptroller.gov/content/dam/mdcomp/tax/legal-publications/administrative-releases/income-and-estate-tax/ar_it3.pdf

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Thank you. Is there any other reason from a tax perspective why he should take the lump sum rather than 12 monthly payments?