Taxing Severance Pay: How the "One-Fifth Rule" Works

Is a severance payment taxable?

Yes. A severance payment made in connection with the loss of a job constitutes compensation for lost income (Section 24(1)(a) of the Income Tax Act (EStG)). The law expressly classifies it as income, but it does not constitute a separate category of income. It remains classified under the category of income from which it originates; for employees, this means income from employment. However, the law provides for a tax reduction: severance payments are classified as extraordinary income (Section 34(2)(2) of the German Income Tax Act (EStG)) and are subject to reduced taxation under certain conditions.

Losing a job is a stressful time. The tax implications, however, are predictable: there is a fixed rule, a calculation method, and a place where it is taken into account. This article explains exactly these three things.

How does the one-fifth rule work, step by step?

The one-fifth rule (Section 34(1) of the Income Tax Act) mitigates tax progression—that is, the increasing tax rate as income rises. It does not tax the entire severance payment at once, but rather one-fifth of it. Ultimately, it multiplies the tax amount by five.

Why will the tax credit only be available through the tax return starting in 2025?

Because the legislature has eliminated them from payroll tax withholding. As of January 1, 2025, employers are no longer required to apply the “fifths rule” when withholding payroll tax: The Growth Opportunities Act repealed paragraphs 9 and 10 of Section 39b(3) of the Income Tax Act (EStG). Assessment and application now take place exclusively during income tax assessment at the tax office in the taxpayer’s place of residence.

In practice, this means that the employer withholds income tax on the severance payment without applying the reduction. The “one-fifth rule” comes into play when filing the tax return. The tax office recalculates the income tax and credits the withheld income tax (Section 36(2) of the Income Tax Act (EStG)).

When does the one-fifth rule apply? The concentration

Two conditions must be met: The payment constitutes compensation for lost income, and it is concentrated within a single tax assessment period. The Federal Fiscal Court describes it as follows: The compensation is received within a calendar year, and in the year of payment, the total income reported is higher than it would have been had the employment relationship continued uninterrupted (BFH, ruling of March 13, 2018, IX R 16/17).

In the case of a mutually agreed termination, the Federal Fiscal Court (BFH) generally assumes that the termination was not initiated solely by the employee, because an employer would not make payments without cause. If the payment is spread over several years, the requirement of a “concentration” is generally not met. Exceptions: see source.

Severance Pay and Unemployment Benefits: What Is the Progression Clause?

Unemployment Benefit I is not taxable, but it increases the tax rate on other income. This is referred to in the law as the “progression clause” (Section 32b(1), sentence 1, no. 1 of the Income Tax Act (EStG)): A special tax rate is applied to taxable income that takes the wage replacement benefit into account.

If someone receives both a severance payment and unemployment benefits in the same year, the special tax rate applies to their total taxable income. The extent to which it increases the rate depends on the amount of the unemployment benefits. However, only one-fifth of the severance payment is included in the calculation of the special tax rate (§ 32b(2) EStG). If a severance payment and unemployment benefits are received in the same year, this provides significant tax relief.

Are social security contributions due on the severance pay?

No, generally not. According to the German Pension Insurance system, severance payments made as compensation for the loss of a job are not subject to contributions.

However, payments are subject to contributions for amounts that settle claims arising from the period up to termination, as well as for compensation paid while the employment relationship continues—for example, in the case of reduced working hours or a lower-paying position. For the distinction in individual cases, see the source.