Have you ever heard of IRS Circular E? Unless you're an HR director at a company or someone else directly responsible for calculating tax withholding on employee paychecks, probably not. And for the most part, who cares? It all comes out in the wash at the end of the year when you file your taxes and "true up" your proper tax burden.
But I just found out the hard way that a provision intended to target "bonuses" paid out to employees REALLY screws employees who have been laid off and receive a severance check.
I was laid off from the company I worked for almost 3 weeks ago. I loved my job, and I had hoped that I would spend the rest of my career there. I was the second employee hired in my office, and had been told in the past that I was being groomed to possibly run the company in the future. But all that is behind me now.
I was fortunate enough to have an employment contract that entitled me to some severance if I was let go without cause, and I had two weeks of unused vacation due to me. At the same time, I have not been making enough money to save anything more than the 4% I was putting in my 401k every month. So the severance I got was pretty much equal to the amount of time I was going to have to find a new job (in a field where there are NO jobs right now), nothing more. I figured it was about 2 months.
Well, today I got my final check, and it was quite a bit less than I had calculated it would be. So I did some math.
My normal paychecks were taxed at a total rate (federal, state, SS, etc) of around 19.5%. My vacation and severance paychecks were taxed at a rate of over 39%!!!
So I called up the HR manager, and she knew exactly what the problem was. This IRS Circular E has a provision for how to tax "Supplemental Wages". From the language of the rule, it's obvious that this rule is intended to primarily apply to bonuses, such as a Christmas bonus or other Wall Street bonuses. But it also applies to severance pay, unused vacation pay, and any other pay outside of a regular pay period.
All supplemental wages "Withhold a flat 25% (no other percentage allowed)." Then you add on the state taxes and SS, etc...
Obviously, this is a significant problem for someone who is out of work and doesn't know where their next paycheck will be coming from. Yes, I'll get the money back next spring when I file my taxes, but I need that money NOW, not in 2010.
I think it would be much more fair to tax supplemental pay at 0%, and make it the responsibility of the taxpayer to pay the taxes on it next year at tax time. That's what they do with unemployment checks, because they know that kind of money is needed NOW, and supplemental pay should be treated the same way. Hell, I don't even mind if some CEO gets his $10 million bonus with a 0% withholding, if we want to treat everyone equally, but at the very least, a person who has just been laid off from his job should not have to withhold taxes on that money that is meant to get them through the tough time until they can find work again. It's just absurdly stupid, to an extent that should even be embarrassing to the IRS.
What I want to know is, who should be alerted to this idiocy in order to make a change in favor of fairness now that we supposedly have a government that will listen to its citizens?