Severance pay (Abfindung) is not subject to social security contributions. But it is subject to income tax.
As you get the whole severance pay in a single month alongside your regular salary, it pushes your taxable income for that month through the roof.
As a result, you pay taxes based on the higher marginal tax rate. This leads to far less severance pay than you expected.
How much severance pay can you get in Germany ->
For example, a 55-year-old woman negotiated a €70,000 severance package with her employer after nearly 20 years of service. When her February payslip arrived, her employer had withheld €29,804 in income tax and €1,639 in solidarity surcharge on the severance alone.
She was left with about €38,500 from the €70,000. This is a loss of €31,500.
How can you save taxes on your severance pay?
#1 One-fifth rule
The one-fifth rule (Fünftelregelung) is a tax relief mechanism designed to reduce taxes on severance pay.
Under the one-fifth rule, the tax office calculates the tax as if you received the severance pay spread out over five years. This reduces your income considered for tax. Hence, lowering your tax bracket and reducing your taxes.
Here’s how the tax office calculates the tax.
- The tax office first determines your income tax without the severance pay.
- Then it adds one-fifth of your severance to your taxable income and calculates the tax on that.
- The difference between the two figures is multiplied by five, and that is the tax you pay on the full severance amount.
Continuing with the above example. If the woman applies the one-fifth rule, she can reduce her tax burden from €31,500 to €15,034.
Important for 2025 onwards: Until the end of 2024, your employer could apply the one-fifth rule directly in your payslip. From 2025 onwards, this is no longer possible. You must now claim it yourself via your annual tax return. So if you receive a severance payment in 2025 or later, do not forget to file your tax return and apply for the one-fifth rule there.
Best tax software in Germany that can handle the one-fifth rule ->
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The following rules apply to be eligible for the one-fifth rule.
- Your severance must be paid as a lump sum. If your employer splits it into installments across different years, the one-fifth rule doesn’t apply. The Federal Fiscal Court (BFH, case no. IX R 10/21) has confirmed this.
- Your severance is at least €1 higher than the wages you would have earned had you worked until the end of the year.
The following two expection applies to the court ruling.
- The installments are spread over two years due to the employer’s financial difficulties.
- A maximum of 10% of the total severance is paid in a different calendar year.
#2 Contribute to your pension plan
You can reduce your tax liability by investing your severance pay in your statutory pension insurance. You can even reduce it to zero via equalization payments into the statutory pension scheme.
Equilization payments allow you to compensate for early retirement deductions.
If you want to retire early (before 67), your pension is reduced by 0.3% for every month you retire early. This means that retiring at 63 will reduce your pension by 14.4% (48 months × 0.3%). You can get these reductions back by making equalization payments.
This method works best if you are 50 or older.
Here is how it works.
- Your employer can pay up to half of the total equalization amount into your pension account.
- Your employer can transfer the equilization amount from your severance package to the pension account.
- As the equilization payment is tax-free, it reduces your taxable income. This results in a lower tax bracket and lower taxes. In certain cases, it lowers your income to the extent that you pay no taxes.
Continuing with the above example. Suppose the lady can pay €42,000 as an equilization amount to avoid any pension reductions in case of early retirement.
The employer could therefore transfer €21,000 (42k / 2) of her €70,000 severance to her statutory pension insurance. This 21k contribution is tax-free. It reduces the taxable portion of her severance from €70,000 to €49,000.
She can further reduce her taxable portion by contributing the remaining €21,000 (42k – 21k) from the severance to her pension account. This second €21,000 is not tax-free. But she can claim it as a special expense (Sonderausgaben) for retirement savings on her tax return.
This reduces the taxable portion of her severance to €28k (49k – 21k).
Other special expenses you can deduct to save taxes in Germany ->
Things to keep in mind before accepting the severance pay
Before accepting a severance payment, think through your financial situation.
- Can you set aside all or part of the money for retirement? If yes, check your equilization number.
- Do you need the severance pay to cover living expenses during unemployment?
- Do you wish to apply the one-fifth rule? If yes, ensure that you get the lump sum severance payment.
Here is how to determine your equilization number.
- Contact the Deutsche Rentenversicherung using form V0210.
- It will tell you how much you need to pay to offset early retirement deductions.
Once you have the equilization number, you can negotiate with your employer about structuring the severance payment.
If the severance pay is large, we recommend consulting a tax advisor (Steuerberater) or a tax assistance association (Lohnsteuerhilfeverein). The cost is worth it when you are dealing with tens of thousands of euros and multiple strategies.
