A severance payment can initially seem like a financial blessing for employees who have been laid off. But the joy can quickly be dampened if the tax burden turns out to be higher than expected. Fortunately, the so-called fifth rule offers a way to reduce the tax burden.
Taxation of severance payments
Severance payments are generally subject to income tax. This means that they are added to taxable income and thus influence the personal tax rate. Since the German tax system is progressive, a large one-off payment such as a severance payment can cause the tax rate to rise significantly. In order to mitigate this effect, the legislature introduced the fifth rule.
How the fifth rule works
The fifth rule fictitiously spreads the tax burden on the severance payment over five years in order to reduce the progression effect. A fifth of the severance payment is added to the remaining taxable income for the year, the tax due on it is calculated and then the difference to the tax without severance payment is determined, according to an online article by the Vereinigte Lohnsteuerhilfe eV. This difference is multiplied by five to determine the total tax burden on the severance payment.
Example calculation: Assume an employee receives a severance payment of 50,000 euros and has an annual taxable income of 40,000 euros. Without applying the fifth rule, the total taxable income would rise to 90,000 euros, which leads to significant tax progression. With the fifth rule, however, a fifth of the severance payment, i.e. 10,000 euros, is initially added to the income, resulting in a fictitious income of 50,000 euros. The applicable tax is calculated, the difference to the tax on the original income is determined and this amount is then multiplied by five. This significantly reduces the tax burden on the severance payment.
Requirements for application
In order for the fifth rule to be applied, certain conditions must be met. The severance payment must be paid as compensation for lost or lost income due to the termination of the employment relationship and must be paid in one sum in the same calendar year. If the severance payment is paid out in several installments, the fifth rule can only be applied if a maximum of 10 percent of the principal amount is paid out in another year.
Changes since 2025
Since 2025, employers are no longer obliged to take the fifth rule into account when deducting income tax. Instead, employees must apply for reduced taxation themselves as part of their tax return, as an online article from steuertipps.de reports. This means that the tax relief only occurs subsequently as part of the assessment by the tax office.
Social security contributions
As a rule, severance payments are exempt from social security contributions. However, there is an exception for those with voluntary statutory health insurance. You may have to pay health and nursing care insurance contributions on the severance pay. It is therefore advisable to consult your health insurance company at an early stage in order to avoid unexpected additional payments, as it says in conclusion.
Dominik Maier, editorial team at finanzen.net
Image sources: Motortion Films / Shutterstock.com, Bartolomiej Pietrzyk / Shutterstock.com
