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What You Should Know About Tax Before Walking Away From Your Job

Dec. 9, 2021, 9:45 AM

A record 4.4 million Americans left their jobs in September 2021—more than the previous record, set the month before. It’s a phenomenon that has been dubbed “The Great Resignation.”

The evidence suggests that many of those who have left the workforce intend to return. That certainly bears out in my conversations. Most of my friends and colleagues who have quit their jobs have done so out of frustration, exhaustion, or worry about a lack of work-life balance. They will, they assure me, come back to work eventually—they’re just aiming to re-evaluate their life choices following the pandemic.

The statistics seem to back up those anecdotes. The data indicating those massive resignations also show brisk hiring patterns. In September—the same month that resignation numbers hit 4.4 million—new hires rang in at 6.5 million.

Of course, not everyone is checking out and immediately checking back in: Some are returning to the workplace a little more slowly. The choice to sit out a few weeks, months, or possibly years raises the question: How will you pay the bills?

Americans aren’t known for their rainy day saving. According to the Federal Reserve, American households had a median balance of $5,300—and an average balance of $41,700—in savings, checking, money market, and call bank accounts, including prepaid debit cards, in 2019.

So what comes next? Here’s a look at some of the options available—and their tax consequences.

Unemployment Compensation

I know—you’re surprised to see this on the list. It’s true that many employees who leave their jobs are not eligible for unemployment—but not all. The reason for leaving your job matters, and resigning for “good cause” may still result in benefits, depending on your state.

If you are eligible for unemployment benefits, you should understand that for federal income tax purposes, those benefits are considered compensation and are taxable. A recent change in the law excluded up to $10,200 of unemployment compensation from tax for taxpayers with modified adjusted gross income (AGI) of less than $150,000. However, that exclusion was only effective for 2020. Amounts paid in 2021 and beyond remain fully taxable, barring another congressional push.

Separation Packages

Depending on the company, you may be entitled to a separation package when you leave your job—even if you do so voluntarily. For federal income tax purposes, most payments made as part of a separation or severance package will be treated as wages which means they are generally taxable. Employers have some options when paying out wages, including how they calculate withholding—you’ll want to pay attention to make sure that you’re having enough tax withheld so that you aren’t left with a tax bill the following year.

A quick word of warning: Depending on the amount of the payments, you might find yourself temporarily boosted into a higher federal income tax bracket. A little tax planning could go a long way here. It may be beneficial to split payments into two years—assuming that’s an option. Or, if you don’t need the money immediately, consider directing the funds into a tax-favored retirement account.

Retirement Benefits

Employees may want to reach into their retirement accounts as a way to make ends meet. Depending on your age and circumstances, this could result in significant tax consequences.

Withdrawing funds from a retirement plan or IRA before age 59½, or the plan’s normal retirement age, typically means the money must be included in gross income and subject to tax—plus an additional 10% tax on the distribution. To make sure it gets its share of the tax payable, the IRS generally requires automatic withholding of 20% of the amount withdrawn early from a retirement plan like a 401(k) plan, or 10% of the amount withdrawn early from a traditional IRA. That means that a $25,000 withdrawal could leave you with just $20,000 in hand—and you still have to pay any overages due plus the 10% additional tax at tax time.

After you reach age 59½, you can generally receive distributions without paying the 10% additional tax. But that doesn’t make the transaction tax-free since you will still be responsible for paying the “normal” tax on the withdrawal.

Some exceptions apply to the 10% additional tax. Exceptions applicable to financial hardship include:

  • You have unreimbursed medical expenses that are more than 7.5% of your AGI;
  • The distributions aren’t more than the cost of your medical insurance due to unemployment;
  • The distributions aren’t more than your qualified higher education expenses; or
  • You use the distributions to buy, build, or rebuild a first home.

As for exceptions for coronavirus-related distributions? A previous change in the law did offer some relief, but only those distributions made from Jan. 1, 2020, to Dec. 30, 2020 qualify for the exception—2021 distributions remain taxable.

Clearly, rules related to retirement accounts can be tricky and fact-specific. Failing to follow those rules can result in unexpected tax bills. While the IRS does have some online resources available—Pub 590-B is a good place to start for IRA information—don’t be afraid to ask for help.

Early Social Security Benefits

Employment data suggest that nearly two million more seniors have retired during the pandemic than would normally have been expected. That may make good financial sense for some, but don’t start dipping into Social Security without checking the numbers.

You can typically qualify for Social Security retirement benefits as early as age 62. But your monthly benefit is reduced if you start receiving benefits before your full retirement age.

Full retirement age is based on a formula. It’s age 66 if you were born from 1943 to 1954, and increases with time. For those born 1960 or later, full retirement benefits are payable at age 67. You can find your full retirement age using the Social Security Administration’s full retirement age chart.

Once you reach retirement age, whether your Social Security benefits are taxable depends on your filing status and how much other income you receive. If your only source of income is your Social Security check, your benefits are generally not taxable. But if you receive income from other sources, your benefits are taxed if your modified AGI is more than the base amount for your filing status. As a rule, the higher your total income, the higher the percentage of your Social Security benefits subject to tax.

That means that claiming your benefits early—especially if you’re still receiving compensation or other income from your employer—could result in both a lower monthly payment and a higher tax bill. A good tax adviser can help you decide what is the best time to claim benefits in your situation.

Borrowing Against Your Home

With home prices soaring, you might be tempted to tap into the equity in your home with a home equity loan or home equity line of credit (HELOC). With those kinds of loans, you’re borrowing against the equity in your home, using your home as collateral. That can be useful for homeowners who might not otherwise have the liquidity to pay bills during a period of unemployment. Just remember that under current law, you can no longer deduct the interest from a loan secured by your home if you don’t use the money to buy, build, or substantially improve your home. When doing the mental calculations as to whether a home loan is worth it, don’t make the mistake of assuming you can continue to deduct all home debt-related interest.

Personal Loans

Personal credit cards and bank loans may come in handy when bridging periods of unemployment, but they’re not tax-deductible. That may be obvious to younger taxpayers, but older taxpayers may still remember when credit card interest was deductible—that changed in 1986. Businesses may still deduct loan interest, including credit card interest, but you cannot deduct the interest you paid on personal loans. If a loan is part business and part personal, you must pro-rate the interest between personal and business use.

The Bottom Line

At the end of the day, there may be many reasons to walk away from your day job, but make sure that you have a well-thought-out plan for paying your expenses. Don’t assume that all resources are equal—the tax consequences can vary depending on your age, filing status, and personal situation. It’s always a good idea to check with your tax adviser if you have questions.

This is a weekly column from Kelly Phillips Erb, the Taxgirl. Erb offers commentary on the latest in tax news, tax law, and tax policy. Look for Erb’s column every week from Bloomberg Tax and follow her on Twitter at @taxgirl.

To contact the reporter on this story: Kelly Phillips Erb in Washington at