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Unexpected Windfall or Financial Pitfall? Navigating the Tax and Financial Consequences of Losing Your Job
Article Highlights:
Severance Pay
Unemployment Compensation
Health Insurance
o COBRA
o MarketplaceEmployer Retirement Plans
Repaying Retirement Plan Loans
Moving and Home Sale
Navigating the Financial Consequences
Losing a job is a significant life event that not only affects your immediate emotional well-being but also has profound tax and financial implications. From severance pay to unemployment benefits, health insurance options, and the fate of your employer pension plan, each aspect requires careful consideration to navigate the financial turbulence that follows job loss. This article delves into these critical areas, providing a comprehensive overview of what to expect and how to mitigate the adverse effects of unemployment.
Severance Pay - Many companies offer severance packages to employees upon termination. While this payment can provide a financial cushion during your job search, it's essential to understand its tax implications. Severance pay and unused vacation and sick time converted to cash are taxable income, treated similarly to wages. You'll need to report them when you file your taxes, and they are subject to federal, state, and possibly local taxes. Planning for these tax obligations can prevent surprises come tax season.
Unemployment Compensation – If you do not find another job right away, you generally qualify for unemployment compensation. Unemployment benefits are taxable for federal purposes and may or may not be taxable by your state of residence. To minimize the tax you may owe when you file your tax return, you may want to request federal income tax withholding of 10% of the unemployment benefit amount. Do that by submitting a Form W-4V (Voluntary Withholding Request) to your state’s unemployment office.
Health Insurance – If you lose your job and you had health insurance through your employer’s group health coverage plan, you will need to determine your available options for continued coverage via COBRA or a replacement policy. If you give up coverage, you may be subject to penalties in some states for not being insured.
COBRA Coverage -The Consolidated Omnibus Budget Reconciliation Act (COBRA), enacted in 1985, requires continuation coverage to be offered to covered employees, their spouses, former spouses, and dependent children when group health coverage would otherwise be lost. COBRA continuation coverage is often more expensive than the amount that active employees are required to pay for group health coverage because the employer usually pays part of the cost of employees’ coverage, whereas 102% of the total cost can be charged to individuals receiving continuation coverage (the extra 2% covers administration costs). COBRA generally applies to private-sector employers with 20 or more employees and state or local governments that offer group health coverage to their employees. In most cases, COBRA coverage is limited to 18 months.
Health Insurance Marketplace Coverage – When existing health coverage is lost, a family may purchase health insurance through a government health insurance marketplace outside of the normal enrollment window. In addition, depending upon your income for the year, you may qualify for the premium tax credit for the part of the year when you don’t have coverage through your employer, which will help pay for the insurance.
If your coverage was already through a marketplace and not your employer, you should notify the Marketplace that you’ve lost your job and that your income has decreased, as you may then be eligible for a higher advance premium tax credit. However, also advise the Marketplace once you are employed again so that appropriate adjustment can be made to the advance premium tax credit amount. This may alleviate having to repay some of the credit when you file your tax return.
Employer Retirement Plans - If you have a pension or retirement plan through your employer, deciding what to do with these funds is critical. Options include leaving the money in the existing plan, rolling it over into a new employer's plan, or transferring it into an Individual Retirement Account (IRA). Direct rollovers to an IRA or a new employer's plan are preferable to avoid taxes and penalties. However, if you opt for a distribution, be aware that your employer will withhold 20% for federal taxes, and if you later decide you want to roll over the remainder of the distribution, you'll need to complete the rollover within 60 days to avoid further tax consequences. This is where a tax trap exists; for a distribution where the employer has withheld 20% for federal taxes, only 80% of the funds will be available to roll over and the remaining 20% will end up being taxable unless you can make up the difference with other funds.
In the event you ever want to roll those funds into a new employer’s retirement plan, those retirement distributions should not be comingled with other IRA accounts. In addition, you should arrange for a direct transfer to avoid withholding.
Should you be tempted not to roll the funds over, be aware that the distribution will generally be taxable, and if you are under the age of 59½ there will also be a 10% early withdrawal penalty.
Repaying Retirement Plan Loan – If you have taken a loan from your 401(k) or certain other employer plans and there’s an outstanding loan balance when you leave your job, be prepared to repay the balance within the time specified in your plan’s documents. If you don’t repay the loan some plans allow an offset of your account balance by the unpaid portion of the loan. Failing to repay the loan will cause the unpaid amount (less any nondeductible contributions) to be treated as a taxable distribution that will be reported on a Form 1099-R. If you are under age 59½, there will also be a 10% penalty for an early distribution.
Moving and Home Sale - Job loss may necessitate relocation, especially if new opportunities lie elsewhere. Moving expenses for a job relocation are not deductible for most taxpayers. However, selling your home due to job loss or relocation can have tax implications. If you've owned and lived in your home as your primary residence for at least two of the five years before the sale, you can exclude up to $250,000 of the gain from your income ($500,000 for most married couples filing jointly).
A prorated reduced exclusion applies if you don’t meet the ownership, use or once-every-two-years requirements due to a change in the place of employment and the following are true:
(1)Your change of employment is at least 50 miles farther from the residence sold or exchanged than was your former place of employment (if you are unemployed, 50 miles between the new place of employment and the residence sold or exchanged); and
(2) Your change in place of employment occurs during the period of your ownership and use of the home as your principal residence.
This exclusion can provide significant tax relief during a period of financial uncertainty.
Navigating the Financial Consequences - The financial aftermath of job loss is multifaceted, affecting everything from your daily budget to long-term retirement planning. Here are strategies to mitigate the impact:
Budgeting: Reassess your budget to reduce non-essential expenses. Prioritize savings to cover tax obligations and living expenses during your job search.
Tax Planning: Understanding the implications of severance pay, unemployment benefits, and any withdrawals from or required loan repayments to retirement accounts.
Health Insurance: Compare COBRA and Marketplace plans carefully, considering both cost and coverage, to choose the best option for your situation.
Retirement Funds: Avoid cashing out retirement accounts early to dodge taxes and penalties. Consider rollovers to preserve your savings, maintain tax advantages and preserve your nest egg for retirement.
The tax and financial consequences of losing a job are significant but manageable with careful planning and informed decisions. By taking proactive steps to address these issues, you can minimize the financial impact of job loss and set the stage for a successful transition to new employment opportunities.
Please contact this office for questions and assistance.