The Year You Lost a Job: Severance, Unemployment and the Return That Follows

Losing a job is disruptive enough without the tax questions that come with it. The good news is that most of them are predictable. Here is what a job-loss year looks like on the return, and the handful of decisions that are better made early.

Severance is wages

A severance payment is taxable wages, reported on your W-2 and subject to income tax and payroll taxes. Employers often withhold on it at the flat rate used for supplemental wages, which may be more or less than your actual rate. A large lump-sum severance early in the year can look like a full year's income to the withholding tables, so the total picture is worth checking before you assume a refund.

Accrued vacation paid out is wages too. Any payment for signing a release agreement is wages. There is very little in a separation package that is not taxable.

Unemployment benefits are taxable

Unemployment compensation from the Texas Workforce Commission is federal taxable income. It arrives on Form 1099-G in January. Withholding is optional — you can elect to have a percentage withheld when you apply, and many people do not. If you did not, the benefits produce a tax bill at filing time with nothing paid against it. Electing withholding, or making an estimated payment, avoids the surprise.

The retirement account you left behind

You have options with a former employer's 401(k): leave it, roll it to an IRA, roll it to a new employer's plan, or cash it out. Cashing out is taxable in full and, before the applicable age, carries an additional tax on top. It is the option people take when money is tight, and it is the most expensive one. A direct rollover keeps everything deferred. If the plan sends you a check, there is a time limit to complete the rollover and the withheld portion has to be made up from other funds, which we explained in Form 1099-R: What a Retirement Distribution Means.

If you had an outstanding loan against the 401(k), leaving the employer usually accelerates the repayment deadline, and an unpaid balance becomes a taxable distribution.

Health coverage

Continuing employer coverage through COBRA is paid with after-tax dollars and is not deductible for most people unless medical expenses are itemized and exceed the threshold. Marketplace coverage may come with a premium tax credit based on your projected income, which for a job-loss year can be substantially lower than the prior year. Reporting the income change to the Marketplace during the year keeps the credit accurate and avoids a repayment at filing time.

Job search and moving expenses

Under current federal law, job search costs and moving expenses for a new job are generally not deductible for most taxpayers. Members of the armed forces on certain moves are the main exception.

The self-employment pivot

A lot of people who lose a job start contracting, consulting or a small business in the same year. That income is self-employment income with no withholding, and the quarterly estimated tax obligation starts immediately. The transition from W-2 to 1099 in one year is one of the most common ways people end up owing more than they expected. See W-2 vs. 1099: What New Contractors Get Wrong.

A lower-income year has uses

A year with unusually low income can be the right year for a Roth conversion, for realizing capital gains at a lower rate, or for other moves that would cost more in a normal year. It is worth a planning conversation rather than simply enduring.

Where we come in

Bring the W-2 with the severance, the 1099-G, any 1099-R from the retirement plan, and the Marketplace form if you had coverage there. Our individual preparation and planning covers all of it, and we work with clients throughout Weatherford, Fort Worth and the surrounding counties. Get in touch — the first conversation is free.

The return itself

A job-loss year often produces a return that looks unusual next to the ones before it: a W-2 that stops partway through the year, a 1099-G for unemployment, possibly a 1099-R if retirement money was touched, and sometimes a first Schedule C if contract work filled the gap. None of that is a problem on its own. What matters is that every form is accounted for, that withholding on each piece is compared with what the total picture required, and that credits which depend on income are checked, because a lower-income year can make a household eligible for benefits it never qualified for before.

If this describes your year, bring every form, including the ones from the employer you no longer work for, and the paperwork from any retirement account you touched. We work with families across Weatherford, Benbrook and the Fort Worth area through exactly this kind of transition.

This article is general information, not tax advice. Thresholds, forms and rules change from year to year, so confirm the details for your own situation before you file.

Had a job change this year? Call RD Precision Tax Service in Weatherford at (817) 480-6649, or request a free estimate. Robert has prepared returns for clients across Weatherford, Parker County and the surrounding North Texas counties since 2017.