Anyone who receives a severance payment following termination or a mutual termination agreement is generally required to pay taxes on it. The federal government is now planning tax relief for employees who quickly find new jobs. For employees with particularly high incomes, a new option for terminating their employment in exchange for a severance payment is also being considered. What are the current rules, and what should employers and employees be aware of?

When is an employee entitled to severance pay?

Contrary to a common assumption, employees are not automatically entitled to severance pay upon termination. Such an entitlement may arise, for example, from a social plan, a collective bargaining agreement, a provision in the employment contract, or Section 1a of the German Unfair Dismissal Protection Act.

In practice, severance payments are often agreed upon in a termination agreement or as part of court proceedings regarding protection against wrongful termination. In such cases, the employee typically waives the right to continue the employment relationship. In return, the employer pays compensation for the loss of the job.

How are severance payments currently taxed?

A severance payment is generally subject to tax. However, a genuine severance payment is typically not considered taxable income subject to social security contributions. Therefore, it is generally not subject to contributions for health, long-term care, pension, and unemployment insurance.

From a tax perspective, the so-called “one-fifth rule” can reduce the tax burden. However, the severance payment is not actually spread out over five years. The tax office simply calculates the tax as if one-fifth of the severance payment were added to the rest of the taxpayer’s annual income. The resulting additional tax is then multiplied by five.

This provision can mitigate the progressive tax effect resulting from a large lump-sum payment. However, it does not always offer an advantage. Those who are already subject to the top tax rate even without the severance payment often benefit less.

As of 2025, employers will generally no longer apply the fifths rule when withholding income tax. The severance payment is therefore initially subject to regular income tax withholding, which may result in a higher tax withholding. Any potential tax reduction under the fifth-part rule will only be assessed and, if applicable, taken into account as part of the income tax return. Employees who have not previously been required to file an income tax return should consider doing so starting in 2025—without filing a return, the tax benefit from the fifth-part rule will go unused.

What tax incentives are planned?

Under the announced reform plans, severance payments will be subject to more favorable tax treatment if the affected employee quickly finds new employment.

This is apparently intended to create an incentive to find new employment as quickly as possible after losing a job. The exact amount of the benefit, the timeframe that will still be considered a “prompt transition,” and the documentation that will be required have not yet been definitively determined.

Employees should therefore not yet enter into any termination or severance agreements based solely on the political announcement. The final text of the law will be decisive.

New Termination Option for High-Income Earners

Under the reform plans, employees whose income exceeds 1.75 times the contribution assessment ceiling will be given an additional option to terminate their employment in exchange for a severance payment.

Such a provision could affect, in particular, executives and other employees in the higher income bracket. Employers might find it easier to terminate employment relationships without having to meet all the requirements for a socially justifiable termination. In return, the employee would receive a severance payment, the details of which would be specified by law.

Among other things, the amount of the severance payment, the exact calculation of the income threshold, and the question of whether termination should be possible unilaterally or only with the employee’s consent remain to be determined.

What are the key considerations when planning?

The timing of the payment can significantly affect your tax liability. A payment in a year with little other income may be more tax-efficient than a payment in a year with a high salary or bonus payments.

Employers and employees should also be aware of the implications of a termination agreement for unemployment benefits. Depending on the terms of the agreement, there may be a waiting period or a suspension of benefits. Issues such as leave of absence, unused vacation time, variable compensation, company cars, and company pension plans should also be clearly addressed.

Careful design remains crucial

The proposed changes could make changing jobs more quickly more attractive from a tax perspective and give companies greater planning certainty when parting ways with highly paid employees. However, these changes are not yet law. Until new legislation is enacted, severance payments should continue to be structured in accordance with existing labor, tax, and social security laws.