A sudden, unexpected job loss is one of the most trying financial situations a person can face.
Your focus has to quickly shift to your immediate-term income situation. How much longer will you collect a check? Will you get severance pay? Will you collect unemployment? Will you start a side hustle?
All of the above are forms of short-term financial relief … and all of them have tax implications that you’ll need to understand to prevent an already difficult financial situation from getting messier.
Today, I’ll discuss several common types of income that people receive after being laid off—and the tax implications of receiving that money. This information will not only help you better understand your obligations so you can budget for them, but possibly even influence how you utilize some of these sources of income.
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Types of Taxes Related to Layoffs
Whenever money changes hands, the government usually wants its cut—and unfortunately, that doesn’t change when you get laid off.
There are several transactions related to job loss that either likely or certainly will be taxed. Which means, as you’re mapping out any temporary financial changes until you find new employment, you’ll need to plan for the tax implications, too.
Today, I’m going to review how different types of post-layoff income are taxed. But note that the following addresses federal taxes only. State-level taxation rules vary from one state to the next.
Severance Benefits
Yes. Severance pay, like regular pay, is taxable during the year in which you receive it.
Your previous employer should include the amount on your Form W-2 and withhold applicable federal and state taxes. However, your employer withholding some taxes doesn’t mean you won’t owe more taxes later.
Depending on the timing and amount of your severance pay, you could be bumped into a higher tax bracket. For instance, let’s say you were laid off at the end of October, and your company said you would receive six months’ worth of severance. If that severance is paid out in a lump sum (as it usually is), you’d effectively be earning 16 months’ of pay during that year. Not only would you owe taxes on all that money, but if your severance pay elevated you into the next tax bracket, some of your income would be taxed at an even higher rate.
Which, let me quickly clear up a common misconception: Moving up a tax bracket doesn’t mean all of your income is taxed at a higher rate. Only the amount that pushed you over is taxed at that rate. Still, for the purposes of your own estimating and budgeting, you should be aware that some of your income will be taxed more heavily.
One last consideration here: The overall higher income could cause you to become ineligible for income-based credits or deductions you qualified for previously.
Unemployment Income
Yes. The IRS typically takes its cut of both state unemployment insurance benefits up to 26 weeks, as well as 26 weeks.
You can fill out Form W-4V to ensure 10% is withheld from your benefits for federal tax purposes, which could help to keep you from owing taxes at filing time. Your state should send you a physical or electronic copy of Form 1099-G by Jan. 31 displaying how much you received in taxable benefits the previous year.
Some types of unemployment payments are taxed differently spending on the program paying the benefits. Taxpayers can use an IRS Interactive Tax Assistant tool to determine whether their payments are taxable.
Related: Should You Tap Into Retirement Savings After a Layoff?
Paid-Out PTO
If you’re laid off with little to notice, you might have a lot of unused paid time off (PTO).
What happens with your leftover PTO is somewhat state-dependent—some states require your employer to pay you for any unused PTO when you’re laid off, while other states allow businesses to take a use-it-or-lost-it approach to time off. (Of course, even if your state doesn’t mandate it, your employer might still pay you for that time.)
If you get paid out for unused vacation or sick days, that money is taxable.
Related: Here’s How You Can Lose Medicare [And How You Won’t]
Gig Work
Nowadays, it’s common for recently laid-off workers to pick up gig employment to replace at least a little of their cash flow.
However, if you’ve only ever worked as a W-2 employee (your employer takes taxes out when they pay you), you should know that many gig jobs—such as rideshare driving or selling goods online—is taxed differently.
If you accumulate at least $400 in net earnings from a gig-economy job within a calendar year, you must pay taxes on that income. If you do that work as an independent contractor or freelancer, earnings won’t be withheld from your paycheck. Instead, you’ll need to make quarterly estimated tax payments, which you can read more about on IRS.gov.
On the federal front, quarterly estimated tax payments include income taxes, as well as self-employment taxes (Social Security and Medicare). As a W-2 employee, these taxes are split between you and your employer; as a self-employed worker, the tax burden is solely on your shoulders—but you may deduct the employer-equivalent of your self-employment taxes when calculating your adjusted gross income.
For filing purposes, you’ll receive Form 1099 instead of Form W-2 from any of your gig employers.
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Investment Account Withdrawals
While unemployment benefits and gig work can help recoup at least some cash flow, it could take time for you to get a new job that completely replaces your lost income.
Unfortunately, the bills will keep rolling in regardless.
To cover essential costs, you might decide to pull money out of your investment account. The tax implications of doing so differ depending on the type of investment account involved.
Related: Financial Prep If You’re Worried About Being Laid Off
Taxable Brokerage Accounts
You fund a taxable brokerage account with “post-tax” money (earnings that have already been taxed). As a result, you don’t have to pay any taxes when you withdraw money from your account.
But chances are that most of the funds inside your brokerage account are invested in stocks, bonds, and other securities—so, to free up cash, you’ll need to sell those securities. And that has tax consequences.
If you sell an investment for a profit, you’ve generated a capital gain, which is subject to capital gains taxes. You can read more about this in our capital gains tax primer, but in short:
- If you sell a security you have owned for a year or less, you will pay taxes at the applicable short-term capital gains tax rate, which is the same as your “ordinary” income tax rate (your tax bracket).
- If you sell a security you have owned for more than a year, you will pay taxes at the more favorable long-term capital gains tax rate, which depending on your taxable income will be 0%, 15%, or 20%.
You can cut down on capital gains taxes through tax-loss harvesting, in which you offset capital gains with capital losses (selling an investment at a loss). For instance, let’s say you sell an investment for a $2,000 long-term gain, but you sell another investment for a $2,000 long-term loss, those transactions would effectively even themselves out, and you would owe no capital gains taxes.
This process can be complex, however. Unless you’re an experienced investor, you might want to consult a financial advisor.
Related: 10 Best ETFs to Beat Back a Bear Market
Tax-Advantaged Retirement Plans
When you invest in a tax-advantaged retirement plan, such as a 401(k) or individual retirement account (IRA), you don’t have to pay taxes on anything that occurs within the account—you don’t pay capital gains taxes, nor do you pay taxes on any dividends or interest income paid out to you.
However, if you have a traditional tax-advantaged retirement plan, you will be taxed when you withdraw money from the account—and if you do so before you reach age 59½, you’ll also owe an additional 10% penalty.
Fortunately, there are a few carve-outs that allow people to skip the 10% penalty. You might be able to take a hardship distribution, which is available to people who recently lost their jobs if there is an “immediate and heavy financial need.” How much you withdraw is “limited to the amount necessary to satisfy the financial need,” the IRS says. You might also qualify for penalty-free distributions through the Rule of 55 or Rule 72(t). The 10% penalty is also waived for specific uses, such as paying health insurance premiums while unemployed or paying expenses for childbirth or adoption. Regardless of whether you’re exempted from the penalty, you’ll still owe taxes at your ordinary income tax rate.
Roth accounts, such as a Roth IRA, work a little differently. Because a Roth IRA is funded with after-tax dollars, you can withdraw contributions (not earnings) at any time without tax or penalty. However, withdrawals of earnings before age 59½ and before your Roth account is five years old will be taxed and penalized. Again, like with regular Roth accounts, there are some exceptions that can keep you from eating a tax penalty, such as being permanently disabled or using money for a first-time home purchase (up to $10,000).
If you’re younger than 59½ but the account has been open for at least five years, you’ll generally only be taxed.
