Taxing Severance Payments (Abfindungen): What to Keep in Mind

The corona pandemic has driven some employers to resort to limited employment. Although short-time work allowance (Kurzarbeitgeld) has saved many jobs, there have been plenty of redundancies because of the COVID-19 pandemic in recent months.

The severance payment (Abfindung) is a one-time special payment that an employer pays an employee on termination of the contract. In doing so, the employee is compensated for losing a job and, more importantly, for the future loss of earnings.

There is no legal entitlement to the amount of Abfindungen. Thus, the amount of payment is not specifically regulated. In general, half a month’s salary per year of work in the company is considered appropriate.

The severance payment is not tax-free. Since 2006 the payment has to be fully taxed, it then counts as extraordinary income (außerordentlichen Einkünfte), as stated in §34 EStG. However, you do not have to pay social security contributions (pension, health, long-term care and unemployment insurance).

Due to the progression, the tax rate increases with increasing income. This can have a negative effect, especially with a high severance payment. Your tax rate would then rise sharply, and you would have to pay more tax.

With the so-called fifth rule or ‘Fünftelregelung’, there is a possibility to cushion the amount of the tax somewhat (regulated in §34 EStG). The full amount is taxed, but only a fifth affects taxes. This is particularly beneficial for people with a large difference between Abfindung and taxable income.

An Example of Calculating The Fifth Rule:

Max Taxmann (tax class I) lost his job and received an ‘Abfindung‘ of 10,000 Euros from his ex-employer. After deducting all expenses (income-related expenses or ‘Werbungskosten’, special expenses or ‘Sonderausgaben’ and extraordinary burdens or ‘außergewöhnliche Belastungen’), there remains a taxable income of 30,000 Euros.

As you can see in the example, the tax savings are rather small. But even for this, two requirements must be met:

1. The severance payment must be paid in one calendar year: To use the fifth rule, you must have received the severance payment ('Abfindung') during a calendar year. During this period, several instalment payments are possible, for example in March, June and September. If there is an additional payment in the following year, this may amount to a maximum of 5 per cent of the main benefit. Otherwise, the tax office can subsequently refuse to apply the fifth rule.
2. There must be a so-called aggregation of income: This means that your income from the severance pay must be higher than the income lost.
   
   Real income for the calendar year + severance pay > real income + income lost through termination.

Your ex-employer pays the taxes for your 'Abfindung'. The employer also checks whether you meet the requirements for the fifth rule.

When you submit your tax return, enter the data in Appendix N, or answer the simple questions Taxfix asks you to submit the tax return for you!

You don't have to submit your documents on the severance payment arrangement (termination agreement and severance payment agreement) together with your tax return, but please keep them. The tax office might request them at a later point. The document also states whether your employer applied the fifth rule. If not, it can be applied in the course of the tax return, and you can still profit from the more beneficial tax regulation.