How Does Unemployment Affect Your Taxes?
Throughout most of 2010, the average unemployment rate in the United States was about 9.6%. With so many people out of work, chances are that you know someone who is unemployed or are unemployed yourself. Now that the 2010 tax year has come to a close, you may be wondering how your taxes are affect by unemployment. If you experienced a period of unemployment during the year, there are several things you need to be aware of so that you are not surprised at tax time.
Being unemployed, even if you were out of work for the entire year, does not exempt you from your tax obligations. You must pay taxes on any income you make, even if that income did not come from a traditional job. Some things that count as income according the IRS are:
- Payments from your previous job
- Payments from your current job if you found work before the year end
- Income from freelance work or odd jobs
- Unemployment benefits
- Interest on savings or checking accounts
- Severance Pay
- Withdrawals from your 401(k) or IRA
- Moving allowances and other benefits
- Dividends from stocks and interest from bonds
This is just a partial list of the things the IRS counts as taxable income. You can find a complete list on the IRS website. Let’s take a closer look at a few of the items on this list.
Unemployment benefits are considered taxable income. Yes, you read that right, Uncle Sam expects you to pay income taxes on the unemployment check you received while you were out of work. This comes as a surprise to many individuals at tax time. In 2009, you didn’t have to pay taxes on the first $2400 in unemployment benefits you received. Unfortunately, this tax break has not been extended to 2010, so you will have to pay taxes on the entire amount. If you did not opt to have part of the unemployment money withheld for tax purposes, you may find that you get less of a tax refund than you were expecting or even end up owing taxes.
How Severance Pay Affects Your Taxes
A severance package can be a godsend if you are out of work, but you should be aware of how it will affect how much tax you owe so that you can be prepared.
If your previous employer did not withhold taxes from your severance pay and payments for unused sick or vacation days, you will have to pay the taxes yourself. If your severance package is large enough, you may also be bumped up to the next tax bracket and have to pay a larger percentage of tax on all of your income for the year. Your previous employer may offer you the option of spreading your severance payments out over several months, often called a continuation of income, rather than getting a single lump sum. If you have this choice and don’t need the large sum of money up front, spreading the payments out may be the best thing to do. Spreading the payments out may reduce your tax burden, especially if you were laid off close to the end of the year. Only the payments you received before the end of the year will be reported on this year’s tax return, so you will only have to pay taxes on part of the severance package and may be able to avoid crossing over into a higher tax bracket. Of course, the following year, you will be responsible for the taxes on the rest of the severance package.
Withdrawing From Your 401(k)
If you made a withdrawal from your 401(K) plan to pay for expenses while you were unemployed, you will have to pay state and federal income taxes on the amount you withdrew. You can have a certain percentage withheld from your withdrawal to cover taxes, but if this amount is not enough, you will have to come up with the difference at tax time. Also, unemployment doesn’t count under the hardship withdrawal rules, so you will have to pay the 10% penalty in addition to the income taxes.
If you already have an outstanding loan from the 401(k) held by your previous employer when you lost your job, you will have 60 to 90 days to repay it in full before it will be considered a withdrawal and subject to the 10% penalty and taxes. You may be able to arrange to make payments to the outside company that administers the 401(k), but this isn’t always an option.
Tax Benefits of Unemployment
Being unemployed isn’t all bad news when it comes to your taxes. If your income dropped below the upper income thresholds for tax deductions and credits, like the child tax credit, earned income credit, saver’s credit and lifetime learning credit, you can claim a larger amount on your taxes. You may also be able to take advantage of several deductions and credits that weren’t available to you before to offset your tax burden.
Job Search Expenses
You can claim many of your job hunting expenses as a deduction on your taxes, even if you don’t end up getting the job. Some of the expenses that are deductible are non-reimbursed travel expenses for job hunting or interviews, placement agency fees, career counseling, resume preparation, phone calls and postage. There are a few limitations to this deduction. You must be looking for work in the same field and you can’t be hunting for your first job.
Your moving expenses may also be tax deductible if you have to relocate for your new job. You must work at least 39 weeks at your new job within the first year after you move, and your new home must be 50 miles further from your old job than your old home was. If you meet the time and distance test for the moving expense deduction, some of the deductions you can make are the cost of packing and shipping your belongings, 30 days of storage, travel and lodging along the way and utility disconnect and connect fees. If your new employer pays to relocate you or gave you a tax free reimbursement for your expenses, you can’t claim them as a deduction. However, if your employer added your relocation reimbursement to your salary, you can fill out Form 3903 and claim your moving deductions.
Expenses Related to Freelance Work
You can also deduct expenses related to freelance work or odd jobs that you did during the year. Some of the things you can deduct are supplies and tools necessary for you to do the job, child care and phone calls. Make sure you keep the receipts for any purchases you make relating to the work you did.
Medical Tax Deduction
The medical tax deduction is another tax benefit you may be able to take advantage of. You can deduct from your taxes any medical costs in excess of 7.5% of your adjusted gross income. You may not have been able to meet this threshold in previous years, but with your total income for the year reduced due to unemployment, you may be eligible this year. In fact, if you are paying for COBRA, it is very likely you will exceed the threshold. Make sure you deduct all of the medical expenses you qualify for. Some of these expenses include insurance payments, medical treatments, dental care, prescription medicines, glasses, contacts, blood sugar test kits, band-aids, thermometers and saline solution.
Understanding exactly how unemployment will affect your taxes is important so that you are not surprised by an unexpected tax bill and you can maximize your deductions and credits. You should consult with a tax professional to make sure you are claiming all the deductions you are entitled to and filing correctly.
If you find that you owe taxes and can’t afford to pay the bill, you should still file your taxes by the due date to avoid having to pay fines. Contact the IRS and ask if you can set up an installment plan to pay any owed taxes over time.
More Information About Unemployment and Taxes
- Filing Taxes When You're Unemployed - H&R Block
Were you unemployed during 2010? H&R Block explains which tax deductions and tax credits can benefit you.
- Tax Help After a Layoff
It seems like adding insult to injury, but if you lose your job and collect unemployment, you'll need to pay taxes on it. That's just one of the things you need to think about if you're out of work.
- Tax Impact of Job Loss--IRS
The Internal Revenue Service recognizes that the loss of a job may create new tax issues. The IRS provides the following information to assist displaced workers.
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