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If you receive a settlement in an employment-related lawsuit; for example, involuntary termination,
the portion of the proceeds that is for lost wages (i.e., severance pay, back pay, front pay) is taxable wages and subject to the social security wage base and social security and Medicare tax rates in effect in the year paid.
These proceeds are subject to employment tax withholding by the payor and should be reported by you as ‘Wages, salaries, tips, etc.” on line 7 of Form 1040.
Yes, the fact that the past employer will withhold and send this through payroll is correct. They will most likely use the flat rate of tax for withholding (25%).
You of course will be able to have any amount refunded to you when you file your tax return that is more than your true liability for the entire year.
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