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I was reading that severance packages get taxed differently from bonuses. But what about accrued PTO/sick time when you leave a company?

I read somewhere that:

the IRS treats a lump-sum payout of unused vacation as “supplemental wages” subject to Social Security and Medicare taxes according to the IRS Publication 15, (Circular E), Employer’s Tax Guide. Any federal income tax withheld will be at the IRS supplemental wage tax rate, depending on whether the supplemental payment is identified as a separate payment from regular wages or combined with regular wages. (For more information, please see Publication 15 and Treasury Decision 9276.)

I read both of those but it's not clear to me if there is any tax advantage to taking a cash lump sum versus something else such as "spending down" all your remaining PTO/sick time hours or negotiating continuing payments at the regular salary rate until your time is used up. I'm not sure what other options there might be. It sounds like a lot of it might depend on how the company reports your income, which means for the "cash out" approach you might be at the mercy of the payroll department.

At the same time, it's also not clear whether there is really any actual difference between the two or if a "cash out" simply front loads the same amount of taxes. In some cases it might be preferable (especially if one doesn't have any other income right away) to not have the "cash out" taxed at the rate as if it were regular income. That is to say, suppose one has 3 months of PTO being cashed out the tax rate is going to be much higher if the assumption in calculating the tax is that is how much is being earned each pay period.

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    One advantage of using your unused PTO time instead of taking a lump sum payment is that it would extend the duration of your benefits. (For example, if you have two weeks of unused PTO, staying nominally employed for two extra weeks would give you two extra weeks on your employer's health insurance plan.) It also could help reach stock vesting dates.
    – jamesdlin
    Nov 21, 2022 at 17:21
  • For a people in a lay-off situation: Payment of PTO can and will affect any unemployment benefits you may receive. Essentially, it is calculated as extra weeks of work, and hence, correspondingly delay your unemployment benefit. This actually happened to me personally!!! Nov 22, 2022 at 13:26

5 Answers 5

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Any federal income tax withheld will be at the IRS supplemental wage tax rate, depending on whether the supplemental payment is identified as a separate payment from regular wages or combined with regular wages

The last time I left a company we were given several options for the payout for PTO.

  • Two weeks at a time, just like a regular paycheck.
  • A lump sum added to the final check
  • A separate lump sum check

If option one was selected the withholding looked very similar to a regular paycheck. It wasn't exact because the other withholding for things like insurance was different.

If the second option was selected the lump sum added to that final paycheck. That made that final paycheck larger than normal. If the payout was for multiple weeks of PTO that check would be gigantic. Because of the way withholding is done, a portion of the check could be pushed into the next bracket, which would mean that too much would be withheld. The excess would be returned with the tax filing the following April.

The third option would result in the federal withholding done at the supplemental rate.

This is what the IRS says in pub 15if the amount of supplemental wags in the year is less than $1,000,000:

Supplemental wages combined with regular wages.

If you pay supplemental wages with regular wages but don't specify the amount of each, withhold federal income tax as if the total were a single payment for a regular payroll period.

Supplemental wages identified separately from regular wages.

If you pay supplemental wages separately (or combine them in a single payment and specify the amount of each), the federal income tax withholding method depends partly on whether you withhold income tax from your employee's regular wages.

  1. If you withheld income tax from an employee's regular wages in the current or immediately preceding calendar year, you can use one of the following methods for the supplemental wages.

    a. Withhold a flat 22% (no other percentage allowed).

    b. If the supplemental wages are paid concurrently with regular wages, add the supplemental wages to the concurrently paid regular wages and withhold federal income tax as if the total were a single payment for a regular payroll period. If there are no concurrently paid regular wages, add the supplemental wages to, alternatively, either the regular wages paid or to be paid for the current payroll period or the regular wages paid for the preceding payroll period. Figure the income tax withholding as if the total of the regular wages and supplemental wages is a single payment. Subtract the tax already withheld or to be withheld from the regular wages. Withhold the remaining tax from the supplemental wages. If there were other payments of supplemental wages paid during the payroll period made before the current payment of supplemental wages, aggregate all the payments of supplemental wages paid during the payroll period with the regular wages paid during the payroll period, figure the tax on the total, subtract the tax already withheld from the regular wages and the previous supplemental wage payments, and withhold the remaining tax.

  2. If you didn't withhold income tax from the employee's regular wages in the current or immediately preceding calendar year, use method 1b.

If given a choice look at which situation helps you between now and next April. A smaller withholding now could help bridge a gap before the start of a new job, but may result in smaller refund next April. In some cases the 22% special withholding rate is equal to the rate used on the last dollar of each paycheck, so the result would be the same either way. In other cases 22% would be to high a rate compared with their normal check amount.

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  • Depending on the salary, special withholding rate may be well below the marginal rate which leaves you with a potentially high bill come tax time in April.
    – littleadv
    Nov 22, 2022 at 16:46
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I was reading that severance packages get taxed differently from bonuses.

Where? That's not true.

But what about accrued PTO/sick time when you leave a company?

They're taxed the same way as any other portion of your earned income, including salary, bonuses, severance, RSU vests, etc.

There's a difference in withholding handling for one-time payments like bonuses, but that doesn't affect the actual tax due, only how the employer is required to handle mandatory withholding.

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My understanding is that payments for unused PTO are simply added to your income and taxed at the normal rate.

If you received it as a lump sum, it's possible that this would push you into a higher tax bracket, and thus it would be taxed more than if it was spread across two tax years. Whether it's a lump sum or paid out over time, if you received it all in one tax year it would make no difference at all. If it ended up spread across two years it might make a difference, as some or all of the PTO payout might land in a higher tax bracket.

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Sort of?

You may have much more flexibility in when you get paid for your PTO. For example, if you plan to stop working at the end of 2025, you may be able to end with a vacation that pushes your actual severance to 2026. If you otherwise don't work in 2026, it would (generally) be very advantageous to do so: the total amount you receive is taxed at a lower effective rate because you end up in a lower bracket in each year.

Other answers have described company policies that allow you to structure that income in other ways; what will be advantageous to you is totally dependent on your specific situation and what options you have available.

None of this is specific to PTO/sick leave though: any time you can (legitimately) choose when to receive income, you have an opportunity to make a tax-advantageous choice.

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This is a very strange corner case which I am posting for interest only (England and Wales):

I recently left a company just before it went bust. I had a significant amount of PTO accrued.

If I had taken my notice period as PTO then I would have been owed normal pay. Once the company was insolvent only the first £800 of this would have been treated as a preferential debt. The rest would have been non-preferential and since there wasn't much left in the bank it would not be paid.

Instead I negotiated with company to waive my notice period and resigned. (I hadn't been there long enough to get any redundancy payment). Somehow the accumulated untaken leave is all treated as preferential, so eventually I expect to receive all the holiday pay (several thousand), rather than just the first £800.

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