Although the job market appears to be booming, some people are still losing or just leaving their current jobs. If you find yourself in this situation, taxes are probably the least of your worries. Yet, depending on the situation and circumstances of the termination/departure, there are a few things you should be aware of. Decisions you make now could affect your current year and future year tax returns.
Taxation of Post-Employment Payments
Unemployment compensation and payments made for any accumulated vacation or sick time, upon termination, are taxable.
Severance pay is also taxable and subject to federal income tax withholding, but some elements of a severance package could be treated differently. For example:
- ISO Stock Sale: If you acquired Incentive Stock Option stocks and sell them, all or part of your gain may be taxed at the lower, preferential long-term capital gain rates, rather than at ordinary income tax rates.
- Golden Parachute Payment: If your employer pays you a “golden parachute payment” upon termination, you may be subject to an excise tax equal to 20% of the payment that is treated as an “excess parachute payment.” Consult with your tax professional if this happens to you as the rules can be very complex.
- Job Placement Assistance: If your employer assists with job placement, upon termination, the value of this usually is tax-free. However, if you are offered the choice between receiving cash or assistance, the job placement assistance would then be taxable.
Most employers that offer group health coverage must provide continuation coverage for a limited time, to most terminated employees and their families, under the COBRA rules. The cost of this coverage may be expensive to you, but the cost of any premium you pay for medical insurance is considered a medical expense. If you itemized deductions on your income tax return and your medical expenses exceed 7.5% of your adjusted gross income, these medical expenses would be deductible on Sch A.
If your medical coverage is paid in part by your ex-employer after termination, you will not be taxed on the value of the coverage. If a foreign-trade-related circumstance resulted in your job loss, you may qualify for a refundable credit for 72.5% of your qualifying health insurance costs.
What is the best option for funds you have accumulated in retirement plans sponsored by former employers? A tax-free rollover to an IRA is often the best move.
If the distribution from the retirement plan includes employer securities in a lump sum, the distribution is taxed under the lump-sum rules. The “net unrealized appreciation” in the value of the stock is not taxed until the securities are sold or otherwise disposed of in a later transaction.
If you have taken out a loan from your employer’s retirement plan, it may need to be paid back immediately (or within a specific time period). Upon termination, unpaid plan loans may be treated as if it is in default. If this is the case, it will be treated as a taxable deemed distribution to you (and depending on your age, could be treated as an early distribution from the Plan resulting in the 10% early withdrawal penalty PLUS income tax).
If you find yourself with a job separation, please reach out to your Wegner tax specialist to plan ahead to minimize any tax surprises.