The $25,000 limit determines if any or how much of your social security benefits will be taxable. The limit takes into consideration 1/2 of your social security benefits plus all of your other income. From this perspective your severance pay will be considered to determine the taxable amount of your social security benefits. Also your interest from your savings and any distributions from your 401(k) would be included in the calculation on how much of your benefits are taxable. For example, if your severance pay is $12,000, your social security benefits are $20,000, and your 401(k) distribution is $5000 then the amount used to determine how much of your benefits are taxable is $27,000 (12,000 + 10,000 + 5000). In this case part of your social security benefits would be taxable.
The severance pay should not affect the amount of benefits you are able to get. I believe this is what you mean when you say you should not be penalized for income received prior to applying for social security. However, the calculation on how much your benefits should be is a completely different matter than the calculation of how much of your benefits are taxable.
Lastly, whether or not to have taxes withheld from your social security will depend on how much other income you have and how much withholding you already have in place. It does not hurt to have some withholding taken from your benefits. If you find that you are getting a large refund, then you can reduce or eliminate your withholding next year. If you choose to not have any withholding for taxes and just see how it plays out, you could end up owing taxes at the end of the year. Whether you would prefer to owe taxes or get a refund is up to you though.
