Losing a Job

These days, the shaky economy—plus global competition and technology advances—can make just about any industry ripe for layoffs. If you get a pink slip, taxes may be the last thing you’re thinking about. So we’ve done the thinking for you.

You may not think of it as pay, but it is to Uncle Sam, who can lay claim to a portion of any severance or unemployment compensation you receive. Also taxable are payments from your former employer for any accumulated vacation or sick time, so be sure that enough taxes are withheld from these.

Watch for that final W-2 form from your former employer as well. The company isn’t required to send it to you right away, but must provide it by January 31 of the year after you leave the company— the same deadline as if you were still employed by the firm.

If it’s named after a reptile, it’s got to be bad, right? Wrong. This “snake” can help keep you healthy. If you leave your job, a federal law commonly known as COBRA (Consolidated Omnibus Budget and Reconciliation Act) requires your employer to let you stay on the company's policy for up to 18 months after you depart. (Note: The law doesn't cover firings for gross misconduct.)

However, there's a catch: You must pay the full cost of the premium, plus an administrative fee. If you're healthy, you may find cheaper premiums than what you'd spend on a COBRA policy. And if you get a high-deductible policy (at least $1,100 for an individual or $2,200 for a family), you may qualify to set up a health savings account, which lets you make tax-deductible contributions and withdraw the money tax-free for qualified medical expenses.

There's a catch here, though: Job-hunting costs are part of miscellaneous expenses reported on Schedule A of the 1040. And miscellaneous expenses are deductible only to the extent that they exceed 2 percent of your Adjusted Gross Income.

Keep your hands out of that retirement cookie jar! If you lose your job, resist the temptation to dip into your 401(k) account. At any age, cashing in the 401(k) means paying tax on every dime you withdraw (unless you have made after-tax contributions). Even worse, if you’re under age 55 in the year you leave your job, you’ll also be hit with a 10 percent tax penalty. And keep in mind that short-circuiting your retirement savings could be disastrous for your long-term financial health.

If you have more than $5,000 in your 401(k) account, you can leave your money with your former employer, where it will continue to grow. However, you may be better off transferring your 401(k) balance to an IRA, where you would have almost unlimited investment options, or to your new employer's 401(k) plan if it accepts rollovers.

Ask your former boss to send your retirement money directly to the new account. If you request that the money be paid to you, with the intention that you’ll personally deposit it into the new plan, the law requires your former plan sponsor to withhold 20 percent of your money for the IRS.

If part of your 401(k) is invested in your company’s stock, be sure to check out the special rules for net unrealized appreciation—a mouthful of a tax-term that could save you money.

TurboTax will help you deal with tax issues related to losing a job—and help you get the biggest possible tax refund.

Updated for tax year 2008