Laid Off? How Severance, Unemployment and Your 401(k) Are Taxed

Severance is taxed as wages and withheld at a flat 22%, unemployment benefits are taxable with nothing withheld unless you ask, and the 401(k) you left behind is the most expensive money you own if you touch it. Those three facts decide most of what a layoff costs, and none of them appear in the paperwork you are handed on the way out.

Severance is taxed as wages, not as a gift

The IRS treats severance as supplemental wages. It goes on your W-2, it is ordinary income, and it carries the same payroll taxes your salary did: 6.2% for Social Security up to the annual wage base, and 1.45% for Medicare with no ceiling.

For income tax withholding your employer picks one of two methods. The percentage method takes a flat 22% of the payment, rising to 37% on anything above $1,000,000. The aggregate method adds the severance to your last regular paycheck and withholds as though that were your normal pay, which usually takes more.

On a $60,000 severance under the percentage method:

State income tax comes off on top of that wherever you live in a state that has one.

The 22% is a withholding rate, not your tax rate

A surprise bill in April usually starts here, and it lands on people whose severance was generous rather than on people whose severance was small.

Severance is added to everything else you earned in the same calendar year. Somebody laid off in October has nine months of salary already on the books, and the severance stacks on top of it. If that pushes the total into the 24% or 32% bracket, the 22% withheld was less than the tax owed, and the difference is due at filing.

On a $150,000 salary plus $60,000 of severance, with the severance falling in a 32% marginal bracket, the shortfall is ten percentage points of $60,000. That is $6,000 owed in April on money that felt fully taxed in October.

The reverse also happens. Somebody laid off in February with little other income for the year may be in the 12% bracket by December, in which case the 22% was too much and comes back as a refund. Neither outcome is a mistake by the payroll department. A flat withholding rate cannot know what your year will look like.

Severance can delay your unemployment benefit

Whether severance stops you claiming, and for how long, is decided by the state rather than by federal rule, and the states genuinely disagree.

Some treat a lump sum as wages allocated to the weeks it covers, which pushes your first benefit week out by however many weeks of pay it represents. Others treat it as a payment for past service and disregard it entirely, so you can claim from the date you stopped working. A few distinguish between severance you were contractually owed and severance offered in exchange for signing a release.

File the claim when you separate rather than when the severance runs out. The state decides the timing, and a late claim cannot be backdated in most places. And where the shape of a package is negotiable, how it is paid can matter as much as how much it is, since instalments and a lump sum are treated differently in some states.

Unemployment benefits are taxable and nothing is withheld by default

Unemployment compensation is federal taxable income. It arrives with no withholding at all unless you file a Form W-4V and elect it, and the only rate available on that form for unemployment is a flat 10%.

Skipping it is the second surprise bill. Six months of benefits at $500 a week is $13,000 of untaxed income sitting in your return, which at a 12% bracket is $1,560 owed and at 22% is $2,860, on money that has already been spent on rent.

States vary again. Some tax unemployment benefits as ordinary income, some exempt them entirely, and a few tax part. The 10% federal election does nothing about the state side, so where your state taxes benefits, that portion has to be set aside deliberately or it becomes a bill.

Electing withholding on a benefit you are living off is unattractive, and it is still the cheaper of the two options. The alternative is borrowing the tax from next year's cash flow at a point when there may not be any.

Four things you can do with the 401(k) you left behind

Leaving a job does not force a decision about the account. Four options exist and three of them are free.

Leave it where it is. If the balance is above $7,000 the plan has to keep it if you want it kept. You lose nothing except the ability to contribute, and you keep whatever the plan's investment menu and institutional fee rates are, which are frequently better than what you can buy retail.

Roll it to an IRA. Widest investment choice, and it consolidates old accounts into one. It also closes off the back-door Roth strategy if you ever want that, because a pre-tax IRA balance triggers the pro-rata rule.

Roll it into the next employer's plan. Keeps everything under one roof and preserves the rule of 55, which an IRA does not.

Cash it out. The expensive one.

Below $7,000 none of that is your decision. The plan may move the balance into an IRA in your name without asking, and below $1,000 it may send you a cheque. That threshold was raised from $5,000 under SECURE 2.0. If you have a small balance at an old employer and have moved house since, the money may already have gone somewhere you have not been told about.

The mechanics of moving it are in transferring a 401(k) from a previous employer, and what happens if the company goes bankrupt or is acquired covers the case where the plan itself is changing hands.

Cashing out costs about a third of it

A withdrawal before 59½ is ordinary income plus a 10% early distribution penalty. The plan is also required to withhold 20% federally before it sends you anything, which is a payment on account rather than the final bill.

On a $50,000 balance for somebody in the 22% bracket:

Just under a third, before any state takes its share, and before counting what the $50,000 would have become had it stayed invested for another twenty years.

Cashing out during a year with severance in it stacks the withdrawal on top of the severance, so it is taxed at your highest marginal rate rather than an average one. The year you are laid off is usually the worst year available to take money out of a retirement account, which is the opposite of when it feels most necessary. Withdrawing from a 401(k) covers the exceptions that avoid the penalty.

The rule of 55 makes a layoff at 55 different from one at 54

If you leave your employer in or after the calendar year you turn 55, you can take money from that employer's 401(k) without the 10% penalty. Income tax still applies. There is no hardship test and no application: separation from service is the whole qualification.

It applies to the plan of the employer you just left, not to plans from earlier jobs, and not to an IRA. Rolling the balance into an IRA to get a wider fund choice destroys the exemption permanently, which is the mistake that gets made in the weeks after a layoff.

It is the calendar year that counts, not your birthday. Leaving in March of the year you turn 55 in November still qualifies.

The plan has to permit partial distributions after separation. Some require the whole balance to come out at once, which makes the exemption useless for anything except a full liquidation.

For somebody laid off at 55 with a bridge to cross, this is frequently the cheapest money available. The same arithmetic in a planned context is in retiring at 50 and the bridge to 59½.

An outstanding 401(k) loan becomes taxable unless you act

If you had borrowed from the plan and have not repaid it when you leave, the plan reduces your balance by the outstanding amount. That reduction is a plan loan offset, and it is treated as a distribution: taxable income, plus the 10% penalty if you are under 59½ and the rule of 55 does not apply.

You are not stuck with it. You have until the due date of your federal tax return for the year you separated, including extensions, to put an equivalent amount into an IRA or a new employer's plan. Do that and the offset is treated as a rollover rather than a distribution, and no tax is due.

The money has to come from somewhere, and a person just laid off with an outstanding plan loan is not usually holding the cash to replace it. The deadline is your filing deadline rather than the ordinary sixty days, which is considerably more generous and considerably less well known.

Unvested employer match is forfeited on the way out

Your own contributions are always yours. The employer's match may not be, depending on where you had reached in the vesting schedule when you separated.

A cliff schedule vests the whole match at once after a set period, commonly three years, and nothing before it. A graded schedule vests a slice a year, commonly 20% a year over five years. Leave a cliff plan at two years and eleven months and you leave the entire match behind.

Where a departure date is negotiable, and in a layoff it sometimes is, the vesting date is worth checking before agreeing to one. A few weeks can be worth a year of match. How matches are structured and where the money can go missing is covered in the 401(k) true-up article and what counts as a good match.

What to do in the first month

File the unemployment claim immediately, whatever your severance is doing. The state decides how the severance affects timing, and most states will not backdate a late claim.

Elect the 10% withholding on benefits unless you are certain you will owe nothing.

Sort health cover inside 60 days. Losing job-based coverage opens a special enrolment period on the marketplace, and COBRA has its own 60-day election window. COBRA charges the full group premium plus 2%, which is what your employer had been paying and you had not seen. The marketplace alternative is priced on your income rather than your assets, and a year with a low income is a year with a large subsidy. What cover costs before 65 works through the calculation.

Leave the 401(k) alone for now. Nothing forces a decision above $7,000, and every option except cashing out stays open indefinitely. Check whether you have an outstanding loan, because that one does have a deadline.

Work out the runway before the search starts. Median searches run over three months, and how long you can fund one decides whether you take the right offer or the first one. How many applications it takes to get an interview has the rates that timeline is built from.

Frequently asked questions

Is severance pay taxable?

Yes. It is treated as supplemental wages, reported on your W-2, and subject to income tax plus Social Security and Medicare. It is not a gift and there is no exemption for it.

How much tax is taken out of severance pay?

Federal income tax is usually withheld at a flat 22% under the percentage method, or 37% on amounts above $1,000,000, plus 7.65% in payroll taxes. That withholding is not the final bill: severance stacks on the rest of the year's income, so a large payment often ends up taxed higher than 22% and the difference is due at filing.

Are unemployment benefits taxable?

They are federally taxable, and nothing is withheld unless you file a Form W-4V and elect a flat 10%. States differ: some tax benefits as ordinary income, some exempt them entirely.

What happens to my 401(k) when I get laid off?

Nothing automatic, above $7,000. You can leave it in the plan, roll it to an IRA, roll it into your next employer's plan, or cash it out. Below $7,000 the plan may move it to an IRA without your consent, and below $1,000 it may send a cheque.

Should I cash out my 401(k) after a layoff?

It is the most expensive money available. Income tax plus the 10% penalty takes about a third before state tax, and the year you are laid off is usually a bad year to do it, because a severance payment in the same year pushes the withdrawal into a higher bracket.

What is the rule of 55?

Leave your employer in or after the calendar year you turn 55 and you can take money from that employer's 401(k) without the 10% penalty. It does not cover IRAs or plans from earlier jobs, so rolling the balance to an IRA gives the exemption up.

What happens to my 401(k) loan if I lose my job?

The unpaid balance is offset against your account and treated as a distribution, so it is taxable and may carry the penalty. You have until your tax filing deadline for the year of separation, including extensions, to roll an equivalent amount into an IRA or a new plan and undo that.

Do I lose my employer match if I am laid off?

You keep whatever had vested. Anything unvested is forfeited, which depends on the schedule: a three-year cliff means nothing vests until three years, and a graded schedule releases a portion each year.