Surviving a Layoff or RIF - Tax and Benefit Planning Strategies
by Tony Novak
Each year more than 10 million Americans lose their jobs unexpectedly. Besides the obvious financial and emotional strain of losing a paycheck and daily social routine, there are also some additional pressures created by decisions that must be made regarding your employer-provided benefits. These choices are irreversible – once they are selected you are locked into the financial effects and tax consequences that might not be fully visible until several years later. But learning the basic tax and benefit planning strategies that apply to your specific situation will give you an advantage and help avoid costly mistakes.
The Retirement Plan
There is one universal rule when it comes to handling your retirement plan: do not cash in your retirement plan directly even if you know that you must use the cash immediately. This rule applies regardless of whether your retirement plan is a self-directed 410(k) or a company-controlled pension plan. First roll it over into your own IRA account and then withdraw money from the IRA as you need it. This will lower your overall tax bill, make more cash available to you now and postpone the date that the tax you owe is actually due. The IRS makes many allowances for individuals to withdraw money from an IRA to pay for expenses while unemployed but these provisions are not available if you simply cash in your employer’s retirement account plan. If you have outstanding loans on your 401(k) plan, the ideal situation is to refinance prior to losing your job. See the notes on “cash flow” section below.
To illustrate the point, consider the following simplified example of two people Jack and Sally, who each have a $10,000 401(k) plan. Jack cashes in his 401(k) plan immediately, while Sally does a rollover to an IRA and then withdraws the money after making a strategy with her financial adviser to take full advantage of the tax saving features of IRA withdrawals. Sally has $2,000 more cash available to her immediately, and ultimately (assuming some very bright financial planning) owes $1500 less tax than Jack.
Jack’s 401(k) Sally’s IRA Account Balance $10,000 $10,000 Tax Withholding Amount2,000$0 Cash Available$8,000$10,000 Early Withdraw Penalty$1500$0 TOTAL TAX$4000$2500
There are many firms that handle these retirement plan rollovers at no charge to you. Some firms also offer tax planning that will allow you to minimize the tax bite while still using as much cash as you need to carry you until your next job. It makes sense to use a firm that assigns a financial adviser that you can rely on later for tax and other advice.
More people have been financially hurt by stock options in the past 24 month period of lagging stock market performance than any other type of benefit plan or financial vehicle. When combined with a loss of employment in a suffering economy, the combined effects can be devastating. Stock options are a great benefit in a rising stock market, but can be an unexpected bombshell in a market downturn. This is because income taxes on stock options are usually triggered before you actually receive any cash from the stock options. If the stock price declines sharply before you sell, you still owe tax on the higher value. In many cases the tax you owe can be greater than the amount you receive from selling your stock or stock options.
To complicate matters even further, stock options are one of the primary triggers of the notorious “alternative minimum tax” (AMT) that catches many taxpayers by surprise. If you find yourself suddenly subject to the AMT, then this might have major implication in your taxes for at least several years into the future due to the “future credit” feature of the Alternative Minimum Tax if you received the type of options known as “incentive stock options”. This can be a much bigger deal than many people realize. Many people who do not complete their financial planning prior to exercising a stock option wind up paying tens of thousands in taxes that might have been avoidable.
Many stock option plans have a provision that causes the options to be exercised at the termination of employment. This means that you have little control over the timing or financial terms of the transaction. In other cases, a terminated employee may exercise the options to raise cash in preparation for losing a salary. In either case, you must act quickly in order to protect
Federal law known as COBRA guarantees that you can keep your medical insurance coverage for up to 18 months if you work for a company with more than 20 employees. But there are many details of this coverage that you should be familiar If your company has less than 20 employees, then COBRA coverage is not available to you under any circumstances. Sometimes an employer may make an arrangement to continue to provide you with group health coverage after your employment is terminated. This is a dangerous situation. If COBRA coverage is not available to you under federal law and the insurance company later learns of a claim on your policy, then the insurer may immediately terminate your insurance coverage and deny responsibility for paying any further claims. The insurer even has the legal right to rescind coverage retroactively back to your date of termination of employment. While most insurance companies do not strictly enforce these severe penalties, it just is not worth taking the risk with your health insurance.
If you are not sure if COBRA applies (for example, your company has had less than 20 employees in the past but has recently grown to more than 20 employees) you should put your request for COBRA coverage in writing to your employer and the insurance company. Usually they will err on the side of caution and offer you the COBRA coverage but this action will not be taken unless prompted by your formal request. Also you should be aware of your state’s unique coverage conversion rules. About half of the states provided for continuity of coverage regardless of COBRA or other provisions.
For most people, COBRA coverage and state-mandated plans are not the best health plan option because of their high cost. Chances are that your current group medical coverage contains many expensive features that you do not need now. If you are usually a healthy person with small medical expenses then it is usually best to switch to a short-term medical insurance plan. These plans cost less because they are not designed to pick up the cost of any expensive pre-existing conditions. They offer more liberal coverage than most group plans because there is no reason to manage claims as tightly as in an employer-sponsored health plan.
It always makes sense to take a conservative view of cash flow when making plans prior to a layoff. If your credit cards, 401(k) loans and other personal debt can be refinanced at more favorable terms, now is the time to do it. There is no legal obligation to tell a lender that you suspect that you may be laid off in the future. But once the layoff happens it is nearly impossible to restructure your debt. If you are not currently monitoring your cash flow on a monthly basis, this is probably an excellent time to start. Use a commercial software program like Quicken to help monitor personal accounting as well as improve personal financial planning.
A special note of caution if you have a 401(k) plan – if you terminate your 401(k) plan participation while you have an outstanding plan loan, the full amount of the loan immediately becomes taxable income and will probably be subject to additional penalty taxes as well. You could wind up owing the IRS almost half of the loan balance. You should make every effort to refinance the loan prior to terminating in the 401(k) plan.
Consider Tax Effects
With an interruption in your income, your tax situation is likely to be entirely different this year. Low and moderate-income taxpayers are more likely to qualify for refundable tax credits in a year when there is a period of unemployment. This can ease the financial bite. Although you avoid adding additional expenses at this time, it makes sense to hire a tax adviser for a couple of hours to rework your tax situation. Finding a tax adviser for the first time may not be easy, but you can improve your chances of getting good advice by looking for an accountant with the credential letters “MT” (Masters of Taxation) or an attorney with the credential “LLM”. This allows you tap directly into the experience of someone with training specifically in the field of tax planning (in contrast with tax return preparation, auditing or public accounting). It may cost a few hundred dollars for this professional help now but could easily wind up saving you thousands in the future.
If you are in a lower or moderate-income bracket, you might find that a layoff actually benefits you financially by placing you in position to receive one or more federal tax credits available. For example, suppose your salary is normally $37,000 but you only worked about half of this year. During that half year of employment you contributed $3,000 to your company 401(k) plan. Now you may qualify for a $1500 tax credit on your income taxes that might not have been available if you had worked the whole year. Since many different types of tax credits and allowable deductions are dependent on overall level of income, having a lower total income this year might have a significant tax-saving effect.
Other Employee Benefits
Group life insurance terminates with your employment. If your recent medical exams indicate any health risk factors (elevated cholesterol or high blood pressure) then it makes sense to consider converting your group term insurance plan to an individual insurance plan. Term life insurance plans are inexpensive but like all term insurance, the coverage will likely expire before you do. If you need permanent insurance then it makes sense to consider asking about a permanent plan at this point. Converting to permanent plans might be a better deal than converting to term insurance because the insurer is more likely to offer their best rates. These “best rates’ are typically not offered to people simply converting from group term insurance to individual term insurance.
When converting any type of insurance plan from a group plan to an individual plan, you can use any qualified insurance agent of your choice. You are not obligated to use the agent who handled your company’s group insurance plan.
Dental plans and other ancillary health plan benefits are typically not included in COBRA coverage or other private conversion plans, so it makes sense to consider the impact of losing these coverages. If you expect to be working for another employer soon then it usually makes sense to “do without” for a few months. But if you will be without group benefits for many months or longer, then you can replace the group benefits with privately purchased benefit plans. Usually PPO discount plans are more cost effective than insurance plans for ancillary benefits like dental, Rx, vision and alternative care.
If you have a Medical Savings Account (MSA) plan, consider that you may not make additional contributions or take qualified tax-free withdrawals for the period of time where the MSA-qualified insurance is not in place. Most people can work around these tax issues to avoid unnecessary taxes and withdrawal penalties, but only if you are aware of them and plan accordingly. MSA account balances can be rolled over, tax-free, into a new account in a procedure similar to a retirement plan rollover.
There may be good news with regard to other benefit plans like medical reimbursement plans, education assistance and dependent care assistance where you have a “use it or lose it” account balance. These are not required to terminate immediately when your employment ends, so you may be able to continue to draw on these for the remainder of the plan year. See your benefit plan description or speak with your company’s benefits officer.
About the author:
Tony Novak, MBA, MT, is a financial adviser based in Narberth, Pennsylvania. He is editor/publisher of “Tax and Benefit News” and moderator of the tax forum for financial planners at “Financial Planning Interactive”. He is available by telephone at 1-877-529-7435 to address public inquiries on tax and benefit planning issues free of charge through OnlineAdviser service sponsored by www.MedSave.com and www.FreedomBenefits.com.