1. Introduction
Regardless of the amount, severance pay is also attractive for employees for not being subject to social security contributions and for its reduced taxation. However, the tax advantages associated with severance pay have now been reduced once again.2. Abolition of the tax allowance as of January 1, 2006
Until 2005, Section 3 (9) of the German Income Tax Act (EStG) provided for tax allowances for severance payments, which were graded according to age and length of service. According to this, up to €11,000 of a severance payment remained completely tax-free and only the amount above this had to be taxed. On January 1, 2006, these tax allowances were abolished, meaning that severance payments have since been subject to income tax from the first euro.
3. One-fifth rule
Since 2006, severance payments have only benefited from the tax reduction under the one-fifth rule in accordance with Section 34 (1) of the Income Tax Act (EStG). This caps tax progression and thus prevents the income tax rate on severance payments added to normal income from being excessively high.
To this end, the severance payment is divided by five and one-fifth is added to the remaining taxable income for the same calendar year. The tax amount that would apply to this fifth is then determined considering it being added to the remaining income of the respective calendar year. This tax amount is then multiplied by five, which gives the tax amount on the entire severance payment. This is intended to achieve the same effect as if the severance payment were spread over five years.
4. Aggregation
The one-fifth rule may only be applied if the compensation is higher than the lost income in the respective calendar year; in other words, if the employee receives more in total from the severance payment and any pro-rata annual income than he would otherwise have earned in that calendar year, this is referred to as aggregation.
5. Ineffectiveness for high earners
However, the fifth rule has no effect if the employee earns so much that they have to pay the top tax rate (42%) on part of their income. For single people, the top tax rate will start in 2026 at an income above €69,879, and for jointly assessed spouses above €139,758.
6. Transfer of the fifth rule to the tax office
With effect from January 1, 2025, the Growth Opportunities Act has stipulated that employers may no longer apply the fifth rule when calculating severance payments in the wage tax deduction procedure; They must subject the severance payment to regular taxation as “other income” (such as a bonus) and initially withhold more income tax and pay it to the tax office – at the expense of the employee.
7. Conclusion and consequences for employees
Employees must now file an income tax return for the year in which the severance payment was received and thus reclaim the tax on the severance payment on a pro rata basis. Since the income tax return can only be filed after the end of the calendar year in which the severance payment was received and is approved even later, employees suffer a liquidity disadvantage. Since it is difficult to determine how high the tax benefit will ultimately be, there is also a risk that the tax advisor’s bill for the income tax return will be higher than the refund.
8. Purpose of the amendment
The change in procedure is intended to help reduce bureaucracy for companies and relieve them of the risk of incorrectly applying the fifth rule (e.g., because there is no accumulation) and having to pay the tax office the insufficiently paid wage tax out of their own pockets. If, on the other hand, the company had deducted too much income tax, employees could – before – claim the costs of the tax advisor as compensation.
9. Summary
The fifth rule for severance payments has not been abolished; it continues to exist, but is no longer applied by employers when preparing the payslip. Employees who receive severance pay from 2025 onwards must now claim the tax benefit from this rule themselves by filing an income tax return or having their tax advisor file it, as this is the only way to reclaim any excess income tax that may have been withheld.
Summary of the key facts
- The tax advantage for severance payments has not been eliminated
- However, employers are no longer allowed to apply the tax advantage when calculating the severance payment
- Employees must claim the tax advantage on severance payments received from 2025 onwards from the tax office
- To do: Income tax return for the year in which the severance payment was received
