Can Severence Pay Be Used for IRA Contributions?

Can Severence Pay Be Used for IRA Contributions?
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There are times when unemployment is sudden and jolting. On other occasions, the newly terminated can see it coming a mile away. Causes could be dissatisfaction of higher-ups, the desire to fill one's position with a more promising recruit or tightened company purse strings. Whatever the reason for separation, many employers offer severance packages to show appreciation for services rendered, to take some anxiety out of the new reality or simply to maintain a good reputation for future hiring.

Most severance packages include cash, often in the amount of a week or more of salary for every year of the employee's tenure. Many ask whether these funds count as earned income for retirement purposes.

What Is Earned Income?

Traditional and Roth individual retirement accounts (IRAs) are helpful and straightforward financial tools to build income for those post-working years. These accounts can offer tax-free withdrawals or tax-deferred contributions. Yet they do place restrictions on what sort of funds are allowable to build their value.

The earned income requirement means that contributions can only be made from wages, salaries, tips, bonuses, commissions and any financial gains from self-employment. Note that bonuses are among the allowable forms of funds.

Is Severance Cash Earned Income?

Why pay attention to bonus pay? An employer is not obligated to distribute bonuses as a form of compensation to employees for services rendered. Whether issuing them is a standard operating procedure or not, doing so is often a subjective decision on the part of management. There is no duty to an employer to pay a bonus.

Likewise, there is no obligation when it comes to severance pay and packages. Both, however, are paid in connection to tasks performed. In the case of a bonus, during the prior year and, in the case of severance, in the course of a career. The bottom line is that bonuses are included in Box 1 of the IRS W-2 form and severance is likewise included. Thus, severance is an acceptable origin for IRA contributions.

Retirement Benefits Part of Severance Package?

Before funneling severance money into an IRA, take time to discern and evaluate any retirement component included in the entire package. Individual states have regulations in this regard as do individual companies. Early retirement offers, for instance, might provide generous cash incentives but may also reduce scheduled pension payment amounts as well.

Moreover, there are "safe harbor" accounting rules to bear in mind with regard to 401(k) accounts. Under safe harbor rules, severance lump sum payouts may not be applied to 401(k)s if issued after the official date of termination.

A safe harbor IRA is one into which an employer may roll a former employee's company-sponsored retirement over if the terminated employee has not touched the funds after a specified period of time. In this way, the company protects the individual's principal while removing it from corporate books. To be clear, this would take place months or years after termination so severance cash contributions are not applicable to safe harbor IRAs.

About Severance Agreements

Besides cash and retirement options, severance agreements made with employers may also include extended insurance coverage. Importantly, the employee usually has ​21​ days to decide whether to accept a severance offer and, once accepted, another seven days to change their mind. Yet the employer is free to terminate at any time, meaning that funds paid out may be received after termination. As noted, this timing changes the eligibility of severance monies as contributions to individual retirement accounts. So, time is of the essence.