I Lost My Job, Now What? Tax Issues of Unemployment, Part 1: Severance Pay

going out of business

Photo by timetrax23 on Flickr.com

First and foremost, I’m sorry for your loss. Losing a job is pretty hard to take and you’re allowed to have a mourning period, but you only get about a day because you’ve got work to do. This post is about taxes and timing —you really don’t want to get burned on your taxes in addition to losing your job.

The first issue I want to discuss is severance pay. If you’re getting any severance pay at all, be glad, so many people aren’t. To a lesser extent, in this category I’m including vacation pay and sick leave that’s owed to you as well. Here’s the important part: if you get laid off in the fourth quarter of the year, try to negotiate to have your severance pay paid to you next year.

Here’s why: let’s say you make an annual salary of $40,000 a year. Your company decides to let go of you right before Christmas (it seems to be a popular lay-off time.) On the plus side, they are giving you one year’s salary as a severance package which is pretty sweet. Here’s the problem—if you’re single and making $40,000 a year, your income tax is going to be under $3600. If your company pays you that severance package before January first, your tax bill won’t be $7200 (which would be double) it will be closer to $13800—over $10,000 more! In this scenario, moving your severance package would save you over $6,000—money that could be used for putting food on the table and paying the rent! Of course, if you’re laid off early in the year, take the money right away—you won’t have that tax problem.

Here’s another reason for moving your severance pay ahead—and this includes your owed vacation pay and sick days as well. That money is still considered to be “earned income” and you want earned income on your tax return. Given today’s economy, it’s possible for you to be out of work for an entire year. Unemployment doesn’t give you access to the Earned Income Credit, but wages do and severance pay is wages. You might not be familiar with the Earned Income Credit if you’re used to having a good job with a good income, but when times are tough it can be a blessing so you really want some wages on your next year’s return.

Will my employer agree to pay me later? I don’t know. The one thing I do know is that if you don’t ask, you don’t get. Here’s his side of it—he’s cutting costs by laying-off staff. If he pays you your severance now, that will reduce his taxable income for the year, so that’s his motivation for paying now—less taxes. But if cash is a little short, by paying you in January, it buys him a little breathing room. If he pays your severance in January, then it also postpones when he pays the IRS your payroll taxes as well. If cash flow is a problem for him, he might jump at the opportunity to delay your payment.

One important issue: if you think the company is going belly up—take the money and run! Pay the tax, deal with it. Realistically, belly up companies aren’t doing severance packages, they’re just paying whatever’s required by law. Get your money, cash the check and be done. Having less money to live on is better than having no money to live on.

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