Most of us expect our income taxes to take care of themselves, except for filing that pesky return: money gets withheld over the course of the year, and then we hope to get some of that back as a refund.
When you leave a job, income taxes can get a bit more complicated. If you're retiring or being laid off, the last thing you need is an unexpected tax bill or penalty. On the other hand, having too much withheld means less money to live on until you get your refund. It's worth thinking ahead to make sure that doesn't happen.
Let's look at some of the ways your income tax situation could change after you leave your job, and a few of the rules that might impact you.
You could see a spike in income – and taxes – when you leave your job.
Will you be paid for unused sick leave or vacation? Are you receiving a severance package? If so, you might actually have more income this year than usual. If you leave your job toward the end of the year and receive those extra payments before December 31, you'll earn a full year's salary PLUS that additional income, all reported on the same year's tax return. Taxes will be withheld from these payments, just as they are from your paycheck. But you might end up owing a significant amount of tax when you file.
Say you're usually toward the top of the 15% income tax bracket. That additional income might be in the 25% bracket, and your usual withholding rate will be too low to cover it.
If you have control over when you leave your job and you expect to receive a significant amount of extra income when you do, you might consider waiting until the beginning of the next year to leave. That would push the extra payments into another tax year, when your earnings for the rest of the year could be less if you're retiring or starting a business of your own.
Starting a business = self-employment tax
Do you plan to start your own business after you leave your job? If you make a profit, that will be taxable income. In addition to federal and state income taxes, you'll also have to pay self-employment tax, consisting of Social Security and Medicare taxes. As a self-employed person, you pay both the employee and the employer portion, totaling 15.3%. That can add up fast and result in a significant tax bill when you file. You may need to pay estimated taxes.
On the other hand, a new business might have a loss instead of a profit, and reduce the amount of taxes you owe. In that case, you might be looking for ways to reduce tax withholding.
You may need to request withholding or file quarterly estimated taxes.
Unlike paychecks, withholding from other kinds of income is not always automatic. In some cases, you can request withholding. Otherwise, you may need to file quarterly estimated taxes, due on April 15, June 15, September 15, and January 15.
Unemployment benefits are taxable income. But income tax will not be withheld unless you fill out a Voluntary Withholding Request, Form W-4V and give it to the office making your payments. Another option is to make estimated tax payments. If you don't have tax withheld or make estimated taxes, you could end up owing tax at the end of the year.
Tax will usually be withheld from pension checks and IRA distributions, unless you chose otherwise. You can also have taxes withheld from Social Security benefits and distributions from retirement plans such as 401(k)s.
If you have savings and investments that are not in retirement accounts, you will probably be receiving taxable interest and dividends from those. You may also have capital gains when you sell an investment at a profit, or when a mutual fund generates capitals gains inside the funds. Income taxes are not withheld from these. These sources of income could result in underpayment of taxes, especially for someone whose income has dropped – because you're unemployed, retired, or starting your own business – and these sources of income suddenly make up a larger portion of your taxable income.
Use your spouse's paycheck to adjust withholding
Are you married to someone who receives a paycheck? Your spouse could change the amount withheld by filing a new W4. Your spouse can increase the amount withheld by reducing the number of allowances claimed, or requesting an additional dollar amount to be withheld from each paycheck.
If you expect to get a large refund, do the reverse: have your spouse increase the number of allowances claimed, or stop having any additional amount withheld.
Income tax rules
If you owe money when you file your taxes, you could be charged a penalty. This happens when you owe $1000 or more. Even then, you won't owe a penalty if you've paid at least 90% of what you owe this year or 100% of what you owed last year (110% if last year's AGI was more than $150,000), whichever is less.
The IRS might give you a pass if you're 62 or older (or became disabled) and you retired during that year. File Form 2210 to request a waiver. But after that, expect no mercy on the penalty.
You can avoid both the penalty and having a large tax bill by paying estimated taxes, asking for taxes to be withheld from Social Security or other income, or increasing withholding from you spouse's paycheck.
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This post is part of a series about the decisions faced during a job transition, whether you're being laid off, retiring, or moving to another job. The initial post lists some of the topics I'll address, as well as why I'm writing about this issue. You can find other posts in this series by clicking the category Job Loss on the right side of this screen. Or you can subscribe to our monthly e-newsletter, which provides links to all of our new blog posts.
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