Taxes When You Lose Your Job

Losing a job is stressful, and understanding the tax implications can help you avoid making decisions that make a difficult situation worse. Several financial events that follow a job loss have significant tax consequences that are easy to overlook.

Severance pay is fully taxable as ordinary income, subject to both income tax withholding and payroll taxes, just like your regular wages. Your former employer will include it on a W-2 at year-end. Unemployment compensation is also fully taxable at the federal level — you'll receive a Form 1099-G showing the total received during the year. To avoid a large tax bill in April, you can elect to have 10% federal income tax withheld from unemployment payments or make quarterly estimated tax payments if you have other sources of income.

One of the biggest financial decisions after a job loss involves your 401(k). You generally have several options: leave it with your former employer's plan, roll it into a new employer's plan when you get a new job, roll it into a rollover IRA, or cash it out. Cashing out is almost always the worst option from a tax standpoint — the entire amount is included in your taxable income for the year, and if you're under 59½, you'll also owe a 10% early withdrawal penalty on top of regular income tax. A direct rollover to an IRA or new employer plan avoids all current taxes and preserves the tax-deferred status of the savings.

Health insurance is a major concern after a job loss. COBRA allows you to continue your employer's group plan for up to 18 months, but at full cost (often eye-wateringly expensive). Alternatively, losing employer-sponsored coverage triggers a Special Enrollment Period allowing you to sign up for marketplace insurance through healthcare.gov, and depending on your income, you may qualify for significant Premium Tax Credits to offset the cost. With lower income, you may also qualify for Medicaid. When estimating your annual income for the marketplace, use your best estimate of total income for the year — underestimating can result in having to repay excess credits when you file.

If your income drops significantly in the year you lose your job, it can actually create a tax planning opportunity: you may be in a lower tax bracket than usual, making it a good year for a Roth IRA conversion, realizing capital gains at a 0% rate, or accelerating other income that would normally be taxed at higher rates. Don't overlook the potential benefit of this — a job loss year with reduced income can be one of the best years for certain tax-advantaged moves.