Anyone receiving a severance payment today will experience an unpleasant surprise when their paycheck arrives, and this has nothing to do with any error on the part of the employer. Since January 1, 2025, the one-fifth rule for payroll tax deductions has been abolished. The legislature repealed the relevant regulation to relieve employers of the administrative burden of calculating the tax. As a result, the full amount of payroll tax is initially withheld from the severance payment, even though a tax reduction is actually due.
The one-fifth rule itself has not been abolished. It remains in the Income Tax Act, but is now only applied during the assessment process. In practical terms, this means that anyone wanting the tax reduction must file an income tax return. Without a return, full taxation applies, and the difference is lost. Depending on processing times, it can take many months for the refund to be processed, which is a factor to consider when planning after a separation.
We are Smart Employment Law, a law firm with two offices in Hamburg specializing exclusively in employment law. We advise and represent employees, employers, and works councils. In separation negotiations, it's not just the amount of the severance payment that matters, but also its structure, as the payment date and its designation determine the amount you actually receive. We are lawyers, not tax advisors, so if there's any doubt about the specific calculation, we will consult a tax advisor.
The most important information at a glance
- Tax liability: The severance payment is subject to income tax from the first euro because it is considered income from dependent employment.
- Social security contributions: A genuine severance payment for job loss is exempt from social security contributions because it is not remuneration for work performed.
- Since 2025: The one-fifth rule is no longer taken into account in the wage tax deduction, but only via the tax return.
- Concentration: The discount is conditional upon the compensation being received within a single calendar year. Installment payments are risky.
- Time: Postponing the payout to a year with low other income can significantly reduce the tax burden.
- Separation of positions: Holiday pay and outstanding remuneration are not included in the severance payment because contributions are due on them.
What the one-fifth rule achieves
German income tax is progressive. A large lump-sum payment is added to other income in the year it is received, driving up the tax rate. The one-fifth rule mitigates this effect by spreading the severance payment over five years for tax purposes.
The calculation is done in three steps. First, the tax on the taxable income excluding the severance payment is determined. Then, the tax on this income plus one-fifth of the severance payment is calculated. The difference between these two amounts is multiplied by five, and this amount is the tax on the severance payment. There is no actual spread over five years; this is purely a calculation method.
The benefit varies. It is significant if your other income in the year of severance pay is low, for example, because your employment ended early in the year and you subsequently received unemployment benefits. It decreases if your regular income is already in the upper tax bracket, and it practically disappears if you are already in the top tax bracket. The tax office automatically checks whether the tax reduction is more advantageous and only applies it if it is. You can find more information about the approximate amount of severance pay itself in the guide to... Severance pay upon termination and in our Severance check.
Why the deduction is so high
When paying out the severance payment, the employer treats it as other income and adds it to the anticipated annual salary. Because the reduced tax rate for income tax deductions is no longer applicable, this regularly results in an excessively high deduction. In addition, the solidarity surcharge and, if applicable, church tax are levied.
The employer must itemize the payment separately on the wage tax statement, specifically as compensation subject to reduced taxation. Check this, because without this itemization, the tax office lacks the necessary information, and verifying the tax reduction becomes complicated. Furthermore, ensure that the payroll statement does not treat the severance payment as regular wages or back pay, as this could result in additional social security contributions.
For your liquidity, the new regulation means: Expect a significantly lower net amount in the month of payment than you would under the one-fifth rule. Those who depend on this money should factor this effect into their planning and submit their tax return early.
The prerequisite: concentration of income.
The tax reduction does not apply to every payment, but only to compensation paid as a replacement for lost income. A classic example is severance pay for job loss, whether from a termination agreement, a court settlement, or a social plan.
In addition, there is a characteristic not explicitly stated in the law, but required by case law: the aggregation of income. Firstly, the compensation must generally be received in a single calendar year, and secondly, you must have more income in that year from the payment than you would have earned had your employment continued uninterrupted. With a very low severance payment and termination at the end of the year, this comparison may be unfavorable, in which case the tax reduction does not apply.
Be careful with installment payments over the New Year period. They jeopardize the lump-sum payment and thus the entire tax reduction. Only very limited exceptions are recognized, such as a minor partial payment that is insignificant compared to the main payment, or additional social welfare benefits like the coverage of further education or outplacement costs. If you are offered payment in two installments, the tax consequences should be clarified beforehand.
Social security contributions: often the greater advantage
For tax purposes, severance pay is fully taxable, but not for social security purposes. A true severance payment is not paid for work performed, but for the loss of employment, and is therefore not considered wages. No contributions are due to health, long-term care, pension, or unemployment insurance.
This is precisely why the description of individual items in the agreement is important. If outstanding compensation, a bonus, or vacation pay is included in the severance payment, these amounts do not lose their status: they remain subject to social security contributions, and the contributions will be subsequently reclaimed. Therefore, list such items separately. For information on the treatment of variable components, see our article on... Special payments and bonuses.
A point for those with voluntary statutory health insurance and those with private health insurance: Before receiving the payout, clarify with your health insurance provider how the one-off payment will be treated when calculating your contributions. The procedure varies depending on your insurance status, and a subsequent claim for additional payments can be unpleasant.
The payout time as leverage
What matters is the receipt of payment, i.e., the date of the actual payment, not the date of the agreement. This provides the most effective flexibility. If your employment ends in the fall and you have already received a high salary this year, a payment in January of the following year may be more advantageous, because then only unemployment benefits or a lower salary will be added.
There are two conditions you should be aware of. The postponement must be agreed upon before the due date to be tax-deductible; a subsequent rebooking is insufficient. And you bear a risk of default: if your employer experiences payment difficulties before the new date, you will be in a worse position. Therefore, if the company is in a precarious financial situation, immediate payment is usually the wiser decision, even if it is more expensive from a tax perspective.
Actively negotiate the timing of your departure. In settlements and termination agreements, it's often easier to negotiate than the amount, because it costs the employer nothing. What should be included in such an agreement is explained on our website. Have your termination agreement reviewed, And if you are pressured to sign quickly, it's worth taking a look at the... The requirement of fair negotiation in the termination agreement.
An example of the effect
Two employees each receive a severance payment of €40,000. One leaves on January 31st and subsequently receives unemployment benefits; her taxable salary in the year of severance pay is therefore only a fraction of a year's earnings. The other leaves on December 31st and has received a full year's salary.
In the first case, the one-fifth rule has a significant effect because the remaining income is low, and one-fifth of the severance payment only triggers a moderate increase in the tax bracket. In the second case, the income is already in the upper tax bracket, so the reduction makes little difference. The difference in net income can amount to several thousand euros, even with the same gross payment.
This doesn't lead to a general rule, but rather to the recommendation to perform a comparative calculation before signing. This calculation depends on your other income, marital status, church tax liability, and whether you receive unemployment benefits. This calculation will determine whether deferring payment is worthwhile.
Unemployment benefits, progression clause and suspension
Unemployment benefits are tax-free, but are subject to the progression clause. They are factored into the calculation of your tax rate, thus increasing the tax on your other income, including severance pay. Therefore, anyone receiving unemployment benefits for an extended period in the year of their severance payment is often required to file a tax return and should expect to make a tax payment, which will partially offset the advantage of the one-fifth rule.
Separately, there is the question of social security law. A severance payment does not lead to a waiting period for unemployment benefits, as the waiting period is linked to the type of termination, not the payment itself. However, if the employment relationship ends before the end of the standard notice period and you receive a severance payment, your entitlement to unemployment benefits is suspended for the shortened period. These two mechanisms are often confused, but they operate independently of each other.
Three rarely used adjustment screws
Besides the timing, there are other ways to reduce the tax burden in the year of severance pay. These should be discussed with a tax advisor, but they also need to be negotiated because they require a clause in the contract.
- Occupational pension scheme: Upon termination of employment, a portion of the severance payment can be paid tax-free into a company pension scheme, with the tax-free allowance increasing proportionally to the length of service. This requires the employer's cooperation, therefore the clause should be included in the termination agreement.
- Compensation for pension reductions: Those considering early retirement can offset deductions with a payment to the statutory pension insurance scheme. Such contributions are tax-deductible as retirement savings and have a particularly strong effect in the year of severance pay.
- Advertising expenses and church tax: Legal and court fees incurred in enforcing a severance payment are deductible business expenses. Regarding church tax on extraordinary income, churches often grant a partial waiver upon application; this must be requested and is not automatic.
What belongs in the agreement
From a tax perspective, the agreement should clearly address five points. First, it should be designated as severance pay for job loss, ensuring its exemption from social security contributions and its classification as compensation. Second, the amount should be stated as a gross sum, with a note that you are responsible for paying taxes. Third, the payment date should be specified.
Fourth, the separate listing of other items such as vacation pay, time credits, commissions, and bonuses. Fifth, any contributions to a company pension scheme. Additionally, the reference letter, garden leave, and reason for termination should be addressed. The same applies if the severance payment is agreed upon in a court settlement; see our page on this topic. Unfair dismissal claim before the labor court. Our article on [topic] shows how the height is developing in current practice. Current case law regarding the amount of severance pay.
Citizen's income, garnishment and alimony
The severance payment has implications beyond taxes. Those who rely on basic income support after their unemployment benefits end should be aware that any severance payment is considered an asset for this purpose, provided it remains. Those who use it promptly for appropriate purposes, such as paying off debts or making necessary purchases, are in a different position than those who leave it untouched in their account. Clarify this with the relevant agency early on.
Two further points concern third parties. If there is ongoing garnishment or insolvency proceedings, the severance payment is only partially protected; in some cases, the garnishment exemption limits for earned income apply. Furthermore, the severance payment can be considered income for alimony calculations, often spread over a longer period, because it compensates for lost earnings. In such situations, negotiations regarding the amount and timing of the payment should take these consequences into account.
Here's how to proceed
- Calculate before signing: Consider the gross amount, the expected tax burden, and the payment date together, not just the total sum.
- Separate positions: Have severance pay, holiday pay and outstanding remuneration shown separately in the contract.
- Negotiate the timing: Postpone the payout to a year with lower other income, but assess the risk of default.
- Check the invoice: Check for a separate entry in the wage tax statement; it is not treated as regular wages.
- Submit your tax return: No explanation, no one-fifth rule. Collect receipts for advertising expenses.
- Involve a tax advisor: For comparison purposes and to assess the use of retirement benefits, ideally before signing.
Frequently asked questions about the taxation of severance pay
It's not just about negotiating the amount.
Two severance payments of the same gross amount can differ by several thousand euros in net terms, depending on the payment date and the structure of the agreement. We negotiate both and coordinate the tax implications with your tax advisor. Once an offer is received, Describe your case to us. The initial consultation with a brief assessment is free of charge, and we will get back to you promptly.
author
Raphael Lugowski
Raphael Lugowski is a specialist lawyer for employment law and has been advising employees, works councils, and staff councils in all areas of individual and collective employment law since 2016. His areas of expertise include: protection against dismissal, termination agreements, works constitution law, and employment law at the intersection of digitalization and AI.
Go to author profile →