Severance pay is a voluntary offer of payment by employers to terminated employees. Severance pay may serve as a cushion while you look for work, but if you find a new job quickly it may become a windfall. One option that may be available is tucking that extra money into a traditional or Roth individual retirement account.
IRA Contribution Rules
The Internal Revenue Service classifies severance pay as taxable compensation like wages and salaries. Severance pay is reported on your W-2 form and employers must withhold payroll taxes on the money. The IRS requires that you have taxable compensation at least equal to the amount you contribute to an IRA up to the annual limit. As of 2014, the IRA contribution limit was $5,500. For people age 50 and over, it was $6,500. Since severance pay is compensation, it can be used for IRA contributions.
IRA Income Limits
Severance pay might push you over IRA income limits when it’s added to your other income. For traditional IRAs, this means you might not be able to deduct all or part of your IRA contribution if you or your spouse is covered by a retirement plan at work. If your adjusted gross income exceeds Roth IRA income limits, the effect is to reduce or eliminate the amount of your IRA contribution you can deduct. Limit amounts depend on your filing status. For example, as of 2014, the adjusted gross income limit for a full deduction for a single taxpayer was $60,000, while for a married taxpayer filing jointly, the limit was $96,000.