Converting severance to retirement funds

[cupat1]

My employer is closing down. I've been there for quite some time and I expect to get a generous severance payment. Is there any way to convert that severance payment to a retirement account? 

[SundayInSalem]

We’d have to know more about your severance package to answer your question. Severance payments are generally treated the same as W-2 wages. In such cases, there is no way to convert the money to a retirement account.

Income taxes, social security and Medicare will be withheld from your severance. If your company has a 401(k) or other retirement plan, you can increase your amount you contribute to those plans prior to the shutdown. That will put some money into a retirement account. I assume your 401(k) or other plans will still exist (though it may be converted). Check with your company.

If you have not done so, you can contribute up to $6,000 ($7,000 if age 50 or older) into an Individual Retirement Account.

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[Opus 17]

Severance payments are considered "earned income" and are considered "compensation" for purposes of making contributions to qualified retirement plans.

If your employer offers a qualified plan (401k, 403b, or something similar) you can maximize your participation ($19,500 if under age 50 or $26,000 if age 50 or older).  For example, if you have been contributing $500 per month, you could ask HR to raise your contribution to up to $15,000 for the last month.

You can contribute up to $6000 to a traditional IRA, or Roth IRA, or up to $7000 if you are age 50 or older.  Roth IRA contributions may be disallowed if you also participate in a workplace retirement plan.  You can contribute to a traditional IRA, but it might not be tax deductible if you participate in a workplace retirement plan, depending on your income.

That's the only 2 ways to get new money into a retirement account.

However, one additional option that might be beneficial is to do a Roth conversion.  If you have a pre-tax 401(k), or a traditional IRA, or both, you could do a rollover to a Roth IRA.  This will create a large tax bill, which you can afford to pay thanks to the large severance package.   The long-term advantage is that when you retire, Roth withdrawals are not taxable, so using the severance to fund the tax on a Roth conversion is an indirect way to use the severance to increase your net retirement income. 

[TaxMan29]

Hi,

I received severance 3 weeks after my last day of employment. The severance was equal to several weeks of pay, and was separate then my last pay check and unused PTO.  My employer automatically deducted a percent of the severance to the 401k plan.  Months later this employer is saying that the severance was not eligible for 401k contributions after I have already rolled the 401k to an IRA. They are asking me to send them back a check of the value of the contribution and they will then pay me a direct deposit.

1) Is the severance pay not eligible for 401k pre-tax deductions? 

2) Is there a way to not be penalized by the IRS for taking money that is now in my IRA and sending it back to the employer for them to try to fix the issue?

[SweetieJean]

1) That depends upon the terms of your actual 401(k) plan, as well as the employer's severance policy.  But it sounds like that contribution was made after you had already done the IRA rollover, and this your participation in the 401(k) was "closed."

2) You can try asking the IRS for a waiver of the penalty because of the max up with your employer.

[Opus 17]

@TaxMan29 

Because severance is considered “earned income“, it is considered eligible for 401(k) contributions by the IRS. You will not face any federal income tax consequences for having the money deposited in your 401(k) or for rolling it over to an IRA.

It might not have been eligible under the terms of the employer‘s plan, particularly if the employer matched it.  I’m not clear on what the employer wants you to do, they want you to send them money and then they will send the same amount back? Then it’s a wash. What does it matter?

Did this occur in 2021 or 2022? What are they going to report on your W-2?  Did the IRA rollover occur more or less than 60 days ago?  How much money are we talking about?

As things stand now, I can’t see any negative income tax consequences for you, but I don’t understand what they are proposing that you do and how that might change things down the road.