Losing a Job

Separation pay and other compensation

Any severance pay or unemployment compensation you receive is taxable, as are payments from your old employer for any accumulated vacation or sick time, so be sure that enough taxes are withheld from these. Also, make sure to watch for that final W-2 form from your former employer. 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.

Health insurance

If you leave your job, a federal law commonly known as COBRA requires your employer to let you know that you can continue to be covered by the company's policy for up to 18 months after you depart. (The law doesn't cover firings for gross misconduct.) But 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 can 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.

Job-hunting expenses

You can take an itemized deduction for the expenses you incur in looking for a new job, even if your job search is unsuccessful, but the job you're seeking must be in the same line of work. Eligible expenses include the cost to print and mail your resume, fees paid to an employment or outplacement agency, and travel costs associated with the job search. Keep in mind, however, that job-hunting costs are part of miscellaneous expenses reported on Schedule A of the 1040. Only miscellaneous expenses that exceed 2% of your adjusted gross income are deductible.

Retirement savings

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% tax penalty. And keep in mind that short-circuiting your retirement savings could be disastrous for your long-term financial health.

You have far better options. If you have more than $5,000 in your 401(k) account, you can leave your money with your old employer, where it will continue to grow in the tax shelter. You'll probably be better off transferring your 401(k) balance to an IRA, where you would have almost unlimited investment options. Ask your old boss to ship the money directly to the new tax shelter. If you have the money paid to you, with the idea that you'll deposit it in the new plan, the law requires your old plan sponsor to withhold 20% of your money for the IRS. It's tough to roll over money that's been confiscated by the IRS. Starting in 2008, you'll be able to roll 401(k) money directly into a Roth IRA; for now, if you want to use the Roth option, you must transfer your money to a regular IRA and then convert that account to a Roth. In either case, you have to pay tax on the amount shifted to the Roth IRA, but all withdrawals in retirement can be tax free.

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.

Updated for tax year 2007