Taxes After a Layoff: What You Need to Know

Losing your job has significant tax implications. From severance pay to unemployment benefits to retirement account decisions, understanding the tax rules helps you make better financial decisions and avoid surprises at tax time. This guide covers what you need to know.

Severance Pay and Taxes

Severance Is Taxable Income

The basics:

• Severance pay is taxed as ordinary income
• Federal, state, and local income taxes apply
• Social Security and Medicare taxes are withheld
• Counts toward your total income for the year

Withholding on severance:

• Lump sum: Often withheld at flat 22% federal rate (supplemental income rate)
• Salary continuation: Withheld like regular paycheck
• Neither may match your actual tax liability

Tax Bracket Considerations

Lump sum severance can push you into higher brackets:

If your normal income is $80,000 and you receive $40,000 severance:

• Total income: $120,000
• Some income taxed at higher rate than usual
• May owe more than withheld

Potential strategies:

• Negotiate salary continuation vs. lump sum
• Time severance across calendar years if possible
• Maximize pre-tax deductions
• Contribute to traditional 401(k) or IRA

What Counts as Severance

Taxable as wages:

• Base severance pay
• Accrued vacation/PTO payout
• Retention bonuses
• Prorated annual bonus
• WARN Act pay (if applicable)

May have different treatment:

• Outplacement services (often not taxable to you)
• Health insurance (COBRA subsidy may be taxable)
• Garden leave pay (taxed as wages)

Unemployment Benefits and Taxes

Unemployment Is Taxable

Federal taxes:

• All unemployment benefits are taxable federally
• Reported on Form 1099-G
• No exemption at federal level

State taxes:

• Most states also tax unemployment
• Exceptions: California, New Jersey, Pennsylvania, Virginia, and a few others
• Check your state's rules

Managing Unemployment Taxes

Voluntary withholding:

• You can request 10% federal withholding
• Request at sign-up or later
• Helps avoid tax bill at year end

If you don't withhold:

• Set aside money for taxes
• Consider estimated tax payments
• Plan for tax bill in April

Example calculation:

• Unemployment received: $15,000
• Federal tax (22% bracket): ~$3,300
• State tax (5%): ~$750
• Total tax liability: ~$4,050

Form 1099-G

You'll receive:

• From your state unemployment office
• By January 31 of the following year
• Shows total benefits paid
• Shows any withholding

If incorrect:

• Contact unemployment office immediately
• File with correct amount
• Keep documentation

401(k) and Retirement Account Decisions

Leaving Money in Former Employer's Plan

Tax implications:

• No immediate tax consequence
• Money continues to grow tax-deferred
• No penalties

Considerations:

• May have limited investment options
• May have higher fees
• Less control over account

Rolling Over to an IRA

Tax implications:

• No taxes if done correctly (direct rollover)
• Must be completed within 60 days if check issued to you
• Indirect rollover has 20% mandatory withholding

How to do it right:

• Request direct rollover (trustee-to-trustee)
• Don't have check made out to you
• Complete within deadlines

Cashing Out (Usually a Bad Idea)

Tax consequences:

• Full amount taxed as ordinary income
• 10% early withdrawal penalty if under 59½
• State taxes also apply
• Could push you into higher bracket

Example of the cost: $50,000 401(k) cashed out at age 45:

• Federal tax (22%): $11,000
• Early withdrawal penalty: $5,000
• State tax (5%): $2,500
• Total taxes: $18,500
• You keep: $31,500

Rule of 55 Exception

If you're 55+ when you leave:

• No 10% early withdrawal penalty from that employer's 401(k)
• Applies only to the plan you just left
• Still owe regular income taxes
• Must leave at or after age 55

Important: Doesn't apply to IRAs—only employer plans.

401(k) options guide →

Health Insurance Tax Considerations

COBRA Payments

Tax treatment:

• COBRA premiums paid by you are NOT tax-deductible unless:
  • You itemize deductions AND
  • Medical expenses exceed 7.5% of AGI
• Employer-paid COBRA subsidy may be taxable to you

ACA Marketplace

Premium Tax Credits:

• If income drops, you may qualify for subsidies
• Based on estimated annual income
• Reconciled on tax return
• If income changes, update your estimate

Caution with severance:

• Large severance may reduce or eliminate subsidies
• Calculate carefully before choosing plan
• Consider marketplace vs. COBRA cost comparison

Health Savings Accounts (HSAs)

If you have an HSA:

• You own it—it stays with you
• Can still contribute if you have qualifying plan
• Contributions remain tax-deductible
• Use tax-free for medical expenses

Health insurance guide →

Tax Planning Strategies

Lower Income Year Opportunities

If your income is lower this year:

Roth conversions:

• Convert traditional IRA/401(k) to Roth
• Pay taxes at lower rate
• Future growth is tax-free
• Good if you expect higher income later

Harvest capital gains:

• 0% capital gains rate if income is low enough
• Sell appreciated investments
• "Reset" cost basis for future

Take required minimum distributions (if applicable):

• May be taxed at lower rate than future years
• Plan with overall tax picture

Maximize Deductions

If you itemize:

• Medical expenses (if >7.5% of AGI)
• Job search expenses (currently not deductible federally)
• Moving expenses (only military currently)
• State and local taxes (up to $10,000)
• Charitable contributions

Standard deduction may be better:

• 2024: $14,600 single / $29,200 married filing jointly
• Compare to your itemized total

Retirement Contributions

Traditional IRA:

• Contribute to reduce taxable income
• 2024 limit: $7,000 ($8,000 if 50+)
• Deadline: Tax filing deadline

If you have self-employment income:

• SEP IRA or Solo 401(k) options
• Higher contribution limits
• Reduces taxable income

Estimated Taxes

When You Need to Pay

Estimated payments required if:

• You expect to owe $1,000+ in taxes
• Withholding won't cover your liability
• Common after layoff due to severance, unemployment

How to Calculate

Safe harbor rules:

• Pay 100% of last year's tax liability (110% if AGI >$150,000), OR
• Pay 90% of current year's liability

Payment Deadlines

Quarterly due dates:

• Q1: April 15
• Q2: June 15
• Q3: September 15
• Q4: January 15 (next year)

How to Pay

Options:

• IRS Direct Pay (free)
• Electronic Federal Tax Payment System (EFTPS)
• Credit or debit card (fees apply)
• Check by mail with Form 1040-ES

Stock Compensation Considerations

Stock Options

If you have vested stock options:

• Exercise deadline after leaving (often 90 days)
• Exercising creates tax event
• ISOs: May trigger AMT
• NSOs: Taxed as ordinary income on exercise

Tax planning:

• Consider exercising in lower-income year
• Watch for AMT implications
• Understand your specific option type

RSUs

Tax treatment:

• Taxed as ordinary income when vested
• If already vested, you already paid taxes
• Selling creates capital gain/loss
• Short-term vs. long-term rates apply

ESPP Shares

If you participated in Employee Stock Purchase Plan:

• Holding period affects tax treatment
• Selling within 1 year: Ordinary income on discount
• Longer holding: More favorable treatment
• Track your cost basis carefully

Documenting for Tax Time

Records to Keep

From your employer:

• Final pay stubs
• W-2 (received by January 31)
• Stock compensation statements
• 401(k) contribution records
• Severance agreement

Unemployment:

• Form 1099-G
• Records of benefits received
• Any withholding elected

Other:

• Health insurance premium records
• Any job search expenses
• Self-employment income records
• Estimated tax payments made

Timeline for Tax Documents

January:

• W-2 from employer
• 1099-G from unemployment
• 1099s for any investments

February-March:

• Retirement account statements
• Health insurance forms (1095-A, B, or C)

Common Mistakes to Avoid

Underestimating Taxes on Severance

Problem: Supplemental withholding (22%) may not be enough

Solution: Calculate your actual liability and adjust

Not Withholding on Unemployment

Problem: Tax bill surprise in April

Solution: Elect 10% withholding or make estimated payments

Cashing Out Retirement Accounts

Problem: Lose significant amount to taxes and penalties

Solution: Roll over to IRA; access only if truly necessary

Missing Estimated Payment Deadlines

Problem: Penalties and interest

Solution: Set reminders; use automatic payments

Not Updating ACA Income Estimates

Problem: Subsidy repayment or underpayment

Solution: Update marketplace when income changes

Getting Help

When to Consult a Tax Professional

Consider professional help if:

• Large severance package
• Complex stock compensation
• Significant retirement account decisions
• Major life changes in same year
• State tax complications
• Self-employment income

Finding a Tax Professional

Options:

• CPA (Certified Public Accountant)
• Enrolled Agent (IRS-licensed)
• Tax attorney (complex situations)

Resources:

• IRS Directory of Tax Preparers
• State CPA societies
• AICPA Tax Advisor Referral

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Key Takeaways

1. Severance is taxable — Withholding may not cover actual liability
2. Unemployment is taxable — Consider electing 10% withholding
3. Don't cash out retirement — Taxes plus 10% penalty devastate savings
4. Lower income = opportunity — Consider Roth conversions or gain harvesting
5. Estimated payments may be needed — Avoid penalties with quarterly payments
6. Document everything — You'll need records at tax time
7. Consider professional help — Complex situations benefit from expertise

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Related Resources:

• 401(k) Options After Layoff →
• Health Insurance Options →
• Emergency Budgeting →
• Severance Negotiation →