Is income tax applicable to severance pay in Germany? Unfortunately, employees are required to pay income taxes on their severance pay. In most cases, the full amount is subject to taxation, despite it being a one-time compensation meant to reimburse the loss of long-term employment. However, there are certain advantages, such as the “rule of one-fifth,” which allows for reducing the tax burden by spreading out the payments over multiple calendar years. A small consolation: Severance payments are typically exempt from social security contributions.
What is the reasoning behind imposing income tax on severance pay in Germany?
A severance package is typically provided as compensation for job loss, making it an exceptional payment. However, in Germany, it has been subjected to full taxation for several years, being treated as regular salary. This is the case even though the severance payment can result in a significant increase in tax progression. Nonetheless, there is a minor tax concession known as the “fifth rule.” This allows for a rough estimation of the potential range of one’s severance payment.
On a positive note, most cases do not require social security contributions for the severance payment (as per Section 14 SGB IV). This exemption applies to pension, health insurance, long-term care, and unemployment insurance (although exceptions exist for individuals with voluntary health insurance). Consequently, the following explanations solely address the taxation of severance payments. For comprehensive information on negotiating compensation and other related matters, please refer to our article on severance pay in general.
In the following, we have compiled a few tax tips in case you receive a severance payment.
Using the “one-fifth rule”
The “one-fifth rule” is a mechanism that helps reduce the tax burden on severance payments in Germany. The country operates under a progressive tax system, meaning that higher income levels are subject to higher tax rates. If an employee receives a substantial severance payment at the end of a long-term employment, the tax rate applied to that payment increases accordingly. However, the “fifth rule” allows for the spreading of the severance payment over a period of five years in the tax calculation.
Employers deduct wage tax using this specific wage tax calculation if it results in a lower overall tax amount. The most significant tax-saving effect is experienced by individuals with relatively low regular earnings who receive a substantial severance payment.
It’s important to note that the reduced tax rate on the severance payment is only applicable if the payment is made in one lump sum. In many cases, it may be more tax-efficient to receive the payment in multiple installments. This is because the terminated employee would have lower annual income in the following years (e.g., due to unemployment) and a consequently lower tax base. However, the “one-fifth rule” does not allow for such installment payments.
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For individuals who have the ability to plan their income strategically, another option to reduce the tax burden on a severance payment is to distribute it over multiple years. In these cases, the fifth rule typically does not apply. By anticipating and negotiating the severance payment, for example, in December 2021, individuals can plan for a period of reduced income in the following year, such as taking a break from work. This can result in lower earnings and a lower progression in 2022. By postponing the payment to the subsequent year, the severance payment would only be taxed at that time. Even a slight delay in payment, for instance, from December 31, 2021, to February 1, 2022, can significantly lower the overall tax burden. The specific timing of allocating the payment depends on when the funds are received. However, this decision should be made on a case-by-case basis, taking into account factors such as other sources of income and the overall tax obligations.
Church tax exemption
Is church tax also applicable to severance payments in Germany? Yes, if you are a member of a church, you may need to pay church tax on your severance payment. However, there is a little-known strategy to potentially reduce this tax burden. Generally, church members can request a partial waiver or exemption of half of the church tax paid on their severance payment. This is because the severance payment is considered extraordinary income for church tax purposes. Although there is no legal entitlement to this partial waiver, it has been commonly granted to church members for many years.
It’s worth noting that this waiver of church tax can have a counter effect of increasing income taxes. Since the church tax is partially eliminated, it becomes fully deductible as special expenses. However, the overall impact is still positive, albeit smaller than one might anticipate.
Please be aware that if you decide to leave the church at the same time, the church tax waiver is often denied (according to the decree of the Archdiocese of Berlin, for example). Therefore, it is recommended to first proceed with the application for the waiver before officially leaving the church.
To take advantage of this benefit, you would need to submit an informal application for a partial church tax waiver to the relevant church tax office. In Berlin, for instance, this would be the Archbishop’s Ordinariate. The application must be filed with appropriate supporting documents before the end of the assessment period, once the tax assessment has been issued (as per § 169 AO).
