Tax Insights

Your Guide to State, Local, Federal, Estate + International Taxation

Tax Aspects of Employee Terminations

Although taxes probably are the last thing on your mind after losing or quitting a job, tax aspects of your changed personal and professional circumstances can be significant. Depending on your situation, the tax aspects can be complex, and require you to make decisions that can affect your tax picture this year and for years to come. Here are just a few of the factors to think about.

Although severance pay is taxable and is subject to federal income tax withholding, some elements of a severance package may be specially treated. For example:

  • If you sell stock acquired by way of an incentive stock option (ISO), part or all of your gain may be lightly taxed long-term capital gain, depending on whether you meet a special dual holding period.
  • If you received or will receive what is commonly referred to as a golden parachute payment, you may be subject to an excise tax equal to 20% of the portion of the payment that’s treated as an “excess parachute payment” under extremely complex rules.
  • The value of job placement assistance you receive from your former employer usually is tax-free. However, the assistance is taxable if you had a choice between receiving cash or outplacement help.

You should also be aware that under the so-called COBRA rules, most employers that offer group health coverage must provide continuation coverage to most terminated employees and their families. The cost of any premium you pay for insurance that covers medical care is a medical expense and as a general rule, results in a tax benefit to you if you claim itemized deductions and your total medical expenses exceed 10% (7.5% for those 65 and older) of your adjusted gross income. If your ex-employer pays for some of your medical coverage for a period of time following termination, you will not be taxed on the value of this benefit.

Employees who terminate employment also need tax planning help to determine the best course of action for amounts they’ve accumulated in retirement plans sponsored by their former employer. For most, a tax-free rollover to an IRA is the best move, if the terms of the plan allow a pre-retirement payout. If you are under age 59 1/2, and must make withdrawals from your company plan or IRA to supplement your current income, there may be an additional 10% penalty tax to pay unless you’re positioned to qualify under one of several escape hatches.

Further, any loans you’ve taken out from your employer’s retirement plan, such as a loan from a 401(k) plan, may be required to be repaid immediately, or within a specified period of your termination of employment, or be treated as if it were in default. If the balance of the loan is not repaid within the required period, it will typically be treated as a taxable deemed distribution.

Finally, the expenses, including travel expenses, of hunting for a new job in the same trade or business are deductible as miscellaneous itemized deductions if certain requirements are met.

By Scott Clouse, CPA