3 Important Things to Consider when Evaluating a Severance Package
Key Points:
Receiving a severance package often comes unexpectedly. However, with corporate restructuring and M&A activity on many organizations’ agendas, the topic may come up in one’s professional career in one way or another.
There may be options to consider within a severance or termination agreement, and one should complete a thorough review of what has been presented in an effort to weigh the various implications.
In addition to navigating the prospect of a job loss, cash flow considerations, tax implications and a variety of other impactful topics related to a severance package should be reviewed. This can be especially challenging given the short-term deadlines that are often imposed to accept the severance package.
Whether you are new to an organization or have been with them for decades, being presented with and having to evaluate a severance package is likely to feel like uncharted territory. A severance package is the compensation and benefits that an employee may be entitled to receive when they unwilfully leave employment. Often, severance packages include a strict time frame for evaluation and acceptance, which is sure to add to any other feelings of stress and uncertainty about the circumstances.
Given the significance of a termination, it is important to conduct a thorough review of various topics in an abbreviated amount of time. By stepping back and assessing all the ramifications, one can ensure that despite the job loss, they will be able to better navigate the implications related to their exit and any options they might have for both their present day needs and their long term financial future.
Immediate severance payments vs. long-term retirement incentives
When separating from an employer, it is important to know the details of any options that might be available. In addition to a standard severance package protocol for employees that are terminated, many employers also have retirement status qualifications that can be met based on an employee’s age and years of service. For any individuals close to retirement age, or with several years of experience with the company, it is important to know if those qualifications for retirement have been met.
If retirement qualifications apply, an individual is likely to be offered an option to accept a different set of exit terms from those included in the standard severance package that may be more favorable to the employee. Retirement terms may remove the prospect of a lump-sum severance payment from their departure package in favor of additional benefit related items, such as future stock ownership and long-term incentives that are traditionally not extended to a terminated employee accepting a standard severance.
While acceptance of these revised retirement terms may create some short-term cash flow concerns given the absence of a lump-sum severance payment, it is important to review the alternatives in detail. While on the surface the retirement alternatives may not seem as compelling as a severance payment, they could provide other income streams that may be equally or even more beneficial for one’s long term financial health. A thorough comparison should be completed, considering estimated future values on an after-tax basis.
Tax considerations for the timing of payouts
Whether through a retirement or a separation agreement, an individual departing from an organization may have one or even multiple related payouts coming from the employer in addition to a severance payment. Additional payments might be related to stock option ownership, long term incentive vesting, pension plans, or deferred compensation plans. If these are included, the payouts from these items are likely to occur not only in the year of separation, but may also be spread out over two or more tax years.
When a severance payment is received it is often provided in the form of a lump sum payment shortly after termination. While that type of payment is impactful for alleviating short-term cash flow concerns, the lump sum payment can create a significant increase in taxable income in the year of receipt. These large, one-time payments have the potential to increase the recipient’s income tax exposure by moving them into higher tax brackets.
Whether or not additional payments beyond severance are included, the affiliated tax withholdings from any lump sum payment should be reviewed. Those withholdings may very well fall short of the necessary withholding, which could lead to a significant and often unexpected balance owed on the annual income tax filing.
Any additional payouts that may occur in the form of deferred compensation plans or long-term incentive vesting should also be evaluated both for their tax implications as well as their payout timing. Often, those payments may include some flexibility on receipt or the time of exercise. For an individual already in possession of a large payment from severance in a single income tax year, there may be a benefit to delay the recognition of any additional income to a subsequent tax year, if feasible.
Evaluate health, life, and disability insurance benefits
In addition to compensation, employee benefits and other related items lost as part of the termination should also be evaluated. Upon departure, health insurance coverage will be expected to terminate. Although the employer-sponsored coverage of health insurance costs will end upon separation, coverage through COBRA should be made available for a period of time.
The continuation of coverage through COBRA can remove an element of uncertainty, but there may be alternative options for health insurance coverage that prove to be more cost effective. In addition to ensuring coverage is maintained, departing individuals should be sure to evaluate their coverage options comprehensively, not only specific to costs, but also to the coverage network that the insured will be permitted to utilize.
In addition to health insurance coverage, executives will also typically hold life insurance coverage through their employer, as well as short and long-term disability insurance. Upon departure from the employer, these benefits are likely to end as well, and continued coverage needs should be evaluated. Although the coverage from the employer may terminate, the need for the coverages may still likely remain.
Securing independent coverage for life or disability insurance may be necessary after termination. However, in some situations, the terminating employer may offer a transition of the company sponsored insurance that can provide a continuation of coverage for the terminated employee. If presented, an evaluation of those options and a comparison against independent coverage alternatives is important. This evaluation must be done to determine if they are both cost competitive and appropriate in coverage type for the departing individual’s needs.
Conclusion
Receiving a notice of termination can be an intimidating prospect for anyone to evaluate. Oftentimes, the situations are presented amidst corporate restructuring or problematic financial conditions, which are sure to add more pressure to the impacted individual after their departure from the company.
Although multi-faceted with various considerations, a thorough review of the departure agreement and its options, along with an evaluation of cash flow, lifestyle needs, and tax considerations will ensure the exit is structured as best as possible, both for one’s short-term and long-term financial well-being.
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