The Tax Impact of Losing Your Job
Losing a job is stressful enough, but receiving a large severance package can push you into the highest tax bracket, resulting in a massive TDS deduction.
How the Income Tax Department treats this lump sum depends entirely on the nature of your departure: was it a standard termination, or a structured Voluntary Retirement Scheme (VRS)?
1. Standard Severance Pay (Fully Taxable)
If you are laid off or terminated and the company pays you a severance package (e.g., 3 months' salary as compensation), this amount is fully taxable.
The Income Tax Act classifies this as "Profit in lieu of salary" under Section 17(3). - It is added to your gross salary for the year. - Your employer will deduct TDS on this amount at your applicable slab rate. - There are no specific exemptions for standard severance pay.
Relief under Section 89 If the severance pay is classified as "compensation on termination of employment," you might be eligible to claim tax relief under Section 89. This involves calculating tax across past years to reduce the burden of receiving a lump sum in the current year. You must file Form 10E to claim this relief.
2. Voluntary Retirement Scheme (VRS) Payouts (Partially Exempt)
If you accept a payout under a formal Voluntary Retirement Scheme (VRS) or Voluntary Separation Scheme (VSS), the tax rules are much friendlier.
Under Section 10(10C), compensation received upon voluntary retirement is tax-exempt up to ₹5,00,000.
Conditions for Exemption: - The scheme must comply with Rule 2BA of the Income Tax Rules. - You must be an employee of a public sector company, local authority, cooperative society, university, IIT, IIM, or a notified private company. - You must have completed 10 years of service OR be 40 years of age. - This exemption can only be claimed once in a lifetime.
If you receive ₹8 lakhs under VRS, ₹5 lakhs is tax-free, and the remaining ₹3 lakhs is added to your taxable salary.
Severance vs VRS
| Payout type | Tax treatment |
|---|---|
| Standard severance / ex-gratia | Fully taxable u/s 17(3) |
| Compliant VRS / VSS | Exempt up to Rs 5,00,000 u/s 10(10C) |
A compliant Voluntary Retirement Scheme payout is tax-free up to Rs 5,00,000 once in a lifetime, while ordinary severance is fully taxable. Source: Income Tax Act Sections 10(10C) and 17(3); Rule 2BA.
What you should do
- Identify whether your payout is plain severance or a compliant VRS
- For VRS, claim the Section 10(10C) exemption (max Rs 5,00,000, once ever)
- If severance is "compensation on termination", consider Section 89 relief with Form 10E
- Match the taxable and exempt split to your Form 16
Common mistake
Assuming every exit package is partly tax-free. Only a Rule 2BA-compliant VRS gets the Rs 5,00,000 exemption; ordinary severance is taxed in full.
How to Report in ITR
Your employer will report the payout in your Form 16. - For standard severance, it will appear under Section 17(3) in your gross salary. - For VRS, the exempt ₹5 lakhs will appear under Section 10(10C), and the balance in gross salary.
When filing your return, ensure these figures match your Form 16 exactly. If you are claiming Section 89 relief on severance, remember to file Form 10E first.
Upload your Form 16 to LastMinute ITR to ensure these complex components are mapped correctly to your tax return.