6 Tax Angles to Layoffs

After a robust job market over the last few years, layoffs are now on the rise. Through November 2023, employers have announced nearly 690,000 job cuts this year, an increase of 115% over the same period last year, according to outplacement firm Challenger, Gray & Christmas. This is the highest January-through-November total since 2020. Prior to 2020, the last time layoffs reached this level was in 2009. Clearly, workers are dealing with a new employment dynamic.

More layoffs could be coming soon. U.S. Bureau of Labor statistics show that job cuts tend to spike in December and January as businesses shore up their spending plans for the coming year. Vulnerable industries include the technology, media, retail, financial, and health care and products manufacturing sectors, according to a recent report from Challenger, Gray & Christmas.

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 been rising, reaching the highest rate in about two years.

If you lose your job, taxes probably 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 personal situation. Here's an overview of six common tax issues that you might encounter.

1. Unemployment Benefits

It's important to sign up for unemployment benefits right away after you're laid off. 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 certain time period,
• 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 from the time 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 length of 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 is taxable in the year in which it's received, along with any payments for accrued vacation and sick time. 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 taxes in addition to 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

If you work for an employer that had 20 or more employees in the prior year, 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 very expensive) 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 may be able to 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 his or her plan allows a change before the annual enrollment period. If you're eligible for this option, employer coverage is generally tax-free, while 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:

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.

Roll over to an IRA. If you don't need the money right away, 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.

Roll over to a new employer's plan. If you get another job soon after the layoff and your new employer has a 401(k) or other qualified plan, 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.

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

5. Side Hustles

You might decide to work part time to 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 Door Dash. Naturally, this results in certain 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. It's important for self-employed individuals 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.

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 your SSB tax professional.

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