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Tax Issues When Losing A Job

by | Dec 29, 2023 | job loss

Unfortunately, employees affected by layoffs may also find it challenging to find a new job. The U.S. Department of Labor reports that continued jobless claims have risen, reaching the highest rate in about two years.

If you lose your job, taxes won’t be the first thing on your mind. After all, you’ll have to figure out how to make ends meet and find a new source of income. But you don’t want any tax surprises to complicate matters. The tax effects vary, depending on your situation. Here’s an overview of six common tax issues that you might encounter.

1. Unemployment Benefits

Signing up for unemployment benefits immediately after you’re laid off is essential. To be eligible to receive unemployment benefits under state law, you must:

• Have not voluntarily departed the job without good cause (as defined by state law),
• Have been employed for a specific time,
• Have earned a minimum amount of wages before becoming unemployed,
• Remain available for work immediately, and
• Be physically able to work.

If you’re eligible for unemployment benefits, your first payment will generally be made a few weeks after your claim is completed and processed. The benefits vary from state to state. Some states are more generous than others.

Unemployment benefits are fully taxable. (For 2020, a COVID-relief law temporarily excluded from tax the first $10,200 of unemployment benefits for those with a household income under $150,000. But this tax break is no longer available.)

2. Severance Pay

Companies often pay severance to employees when they implement layoffs or terminations. Generally, it’s based on your wages and the time you worked for the company. Absent contractual obligations, employers are under no legal obligation to provide severance. But many do so voluntarily.

Severance pay and any accrued vacation and sick time payments are taxable in the year they are received. The tax payment process can be simplified if the appropriate amount of federal and state taxes is withheld at payment time. Also, be aware that severance pay is subject to payroll and income taxes.

There’s an important exception: If you benefit from job placement services from an employer as part of a severance package, the value of those services is tax-free.

3. Health Insurance

Suppose you work for an employer with 20 or more employees in the prior year. In that case, the Consolidated Omnibus Budget Reconciliation Act (COBRA) requires the employer to offer to continue health insurance coverage to departing employees for a specified time (typically, 18 or 36 months). This benefit is tax-free, but employees must pay the (generally costly) premiums. In some situations, a 2% administrative fee also may be charged.

Alternatively, you can obtain and pay for health insurance on your own. In that case, you can deduct the cost of health insurance as a medical expense subject to an annual floor. The deduction is currently limited to the excess of qualified expenses, including unreimbursed health insurance, above 7.5% of your adjusted gross income (AGI). Plus, you must itemize deductions to receive any tax benefit.

Important: Married people who lose their jobs may be able to obtain health care benefits through their spouses if the spouse is employed and their plan allows a change before the annual enrollment period. If you’re eligible for this option, employer coverage is generally tax-free. At the same time, unreimbursed payments count toward the medical expense deduction.

4. Retirement Plans

When you “separate from service,” you’re entitled to the vested benefits in your 401(k) or other qualified employer retirement plan. In this situation, you have several options, including the following:

A. Cash out. You can take a lump-sum distribution or a partial distribution of funds. The payout amount is taxed at ordinary income rates, which may be as high as 37%. And you’ll owe a 10% penalty tax on the taxable portion of the distribution if you’re under age 59½ unless an exception applies.

B. Roll over to an IRA. If you don’t need the money immediately, you can roll over funds in your account to an IRA. If you roll over a distribution within 60 days, you won’t owe any tax or penalties. But 20% withholding is mandatory on distributions. A more prudent approach might be to use a direct “trustee-to-trustee transfer” where you never touch the money. This transfer is exempt from tax, and there’s no withholding requirement.

C. Roll over to a new employer’s plan. Suppose you get another job soon after the layoff, and your new employer has a 401(k) or other qualified plan. In that case, you can roll over the funds to the new employer’s plan without any tax liability. The same basic rollover rules generally apply, so you have 60 days to complete the transfer. But, if you miss this deadline, the distribution will be fully taxable.

D. Leave the money where it is. If your old plan permits it, you can keep the money in your account with your former employer, which can continue to compound on a tax-deferred basis. Of course, you no longer work for the employer, so you may be disadvantaged if you do this.

5. Side Hustles

You can make ends meet until you get another full-time job. The “gig economy” provides plenty of opportunities, such as driving for Uber, offering consulting services, or working for DoorDash. Naturally, this results in inevitable tax consequences.

For starters, the income you earn from a gig is taxable. Generally, you’re classified as an independent contractor rather than an employee, so you must report your income from the activities annually on your tax return. You’re also subject to self-employment tax. Self-employed individuals need to make quarterly tax estimates to avoid under-withholding penalties.

On the plus side, you can deduct “ordinary and necessary” business expenses that may offset some of your taxable income. The deductions are claimed on Schedule C when you file your tax return for the year. You must keep records of potential business expenses shuch as:

• Cell Phone
• Internet
• Vehicle Expenses (Mileage Log is Necessary!)
• Advertising, Social Media Websites
• Meals

6. Job-Hunting Expenses

Previously, you could deduct job-hunting expenses as miscellaneous expenses if you itemized, subject to a floor of 2% of AGI for all your miscellaneous expenses. However, the Tax Cuts and Jobs Act suspended deductions for miscellaneous expenses for 2018 through 2025.

For More Information

This is only a brief overview of several potential tax complications relating to layoffs. If you have any further questions, contact me at 856-665-2121.