When you lose your job and find yourself unemployed, income taxes may not be the most important thing on your mind. But during this difficult time, it is important to be aware of the different income tax aspects of your present situation, and the tax consequences of different courses of action you can take, in addition to knowing about potential tax benefits available to you.
The Internal Revenue Service (IRS) has a number of publications that explain different aspects of the income tax law and how they are applied. These publications are referenced as they apply in the following discussion, and can be found on the IRS website at www.irs.gov. For example, IRS Publication 17, Your Federal Income Tax, is a comprehensive guide to individual income tax topics. And there are specific publications that relate to each topic individually.
Severance Pay and Vacation or Sick Pay
Any severance pay or accumulated vacation or sick pay you receive when you leave your job are taxable. Income tax should have been withheld from these payments based on the same rates that were used for withholding tax from your salary or wages while you were working. These amounts will be included in the Form W-2, Wage and Tax Statement, that you should receive by January 31st of the following year. Severance pay and vacation or sick pay are included with your salary and wages and are reported on the same line of your federal income tax return.
You should notify your former employer if you move after you have left your job so that this form can be sent to the correct address. If you lost your job because your employer went out of business, you should still receive a W-2 from your employer or its representative. If you cannot obtain one, the IRS can help you based on the records they have for you.
Unemployment compensation is also taxable. State unemployment insurance benefits, up to 26 weeks, and extended benefits, up to an additional 13 weeks, are taxable. When you apply for unemployment you will normally be asked if you want to have income tax withheld. You can choose to have 10% withheld for federal income taxes by completing Form W-4V, Voluntary Withholding Request. You should receive Form 1099-G prior to January 31st of the following year, showing your total unemployment compensation and the amount of federal income tax that was withheld.
Unemployment compensation is reported on a separate line of your income tax return, on Form 1040EZ, 1040A, or 1040. The tax withheld from your unemployment compensation, and reported on Form 1099-G should be included with the withholding tax reported on Form W-2. The total withholding tax is then reported on the line for “Federal income tax withheld” on your tax return.
Filing An Annual Tax Return
If you have had income tax withheld from your salary or wages and your unemployment compensation, and your gross income is below the limit for which you must file a tax return, it may be to your advantage to file a return anyway. When you are unemployed, your level of income for the year may be lower, and you may be entitled to a refund if too much tax was withheld.
Earned Income Credit
If you have not qualified for the earned income credit in prior years due to your level of income, you may qualify if your total earned income for the year is lower when you lose your job. You should check the requirements to see if you qualify. The earned income credit is a refundable credit; that is, if the credit reduces your taxes below zero, you will be entitled to a refund. You can find the criteria for determining whether you qualify for the earned income credit in IRS Publication 596, Earned Income Credit.
Certain benefits are not subject to federal income tax. Benefits based on need, such as welfare, food stamps, and other public assistance payments are generally not taxable. Payments you receive from a work-training program sponsored by a state welfare agency are not taxable income, provided they are not more than the benefits you would have received otherwise. If you have a disability, the value of goods, services, and cash you receive for training and rehabilitation are not taxable.
Mortgage assistance payments made under section 235 of the National Housing Act are not taxable. And payments made by a state to qualified individuals to reduce their cost of winter energy are not taxable.
Post-disaster grants you receive to help you meet necessary expenses or serious needs such as for medical or dental care, housing, personal property, and transportation, are not taxable. But if you are unemployed as a result of a disaster, your unemployment assistance payments may be taxable as unemployment compensation.
Disaster relief payments are generally excluded from your taxable income when the payments are to reimburse you, or to pay for reasonable and necessary personal, family, and living expenses that result from the disaster. Payments to repair or rehabilitate your home, or replace its contents after a qualified disaster are also excludible.
Relocation payments and home rehabilitation grants made by a local jurisdiction to persons who are displaced and have to move from a flood-damaged residence to another residence are not taxable.
Withdrawals from a Qualified Retirement Plan or IRA
If you take early withdrawals from a pension plan or retirement account, including a 401(k) plan, the withdrawals are generally taxable unless they are rolled over into another qualified retirement plan or IRA within 60 days. If you take out the withdrawals and use them to fund your living expenses while you are unemployed, the withdrawals would probably be taxable.
If you are under age 59 Ã?Â½ you may also be subject to an additional 10% tax on early withdrawals. But this additional tax does not apply when the distribution is made from a qualified retirement plan after your separation from service in or after the year you reach age 55. And there are exceptions for hardship cases; for example if you are totally and permanently disabled, or when you need the money to pay medical expenses that exceed 7.5% of your adjusted gross income, regardless of whether you actually itemize deductions on your tax return for that year.
If you receive a lump sum distribution, there are special rules for calculating the amount of tax. See IRS Publication 575, Pension and Annuity Income, for more information on the rules that govern lump sum distributions, and early withdrawals from pension plans and retirement accounts.
Recovering an IRA Contribution You Made Earlier in the Year
If you had made a contribution to your IRA earlier in the year and you now find that you need that money to pay for living expenses, you can take that contribution back (withdraw it) without incurring any income tax, provided you withdraw the contribution before the due date for filing the tax return for the year during which you made the original contribution. You must also withdraw any earnings on that contribution while it was in your IRA. And, in this case you will not be able to claim a deduction for that IRA contribution.
Selling Investments or Other Assets
If you sell assets or property that you own, such as investments, in order to obtain funds while you are unemployed, you may be subject to income tax if you have a gain on the sale. Depending on the type of property, and how long you held the property, the gain may be ordinary income, subject to tax at the same rate that applies to other taxable income, or it could be a capital gain, either short-term or long-term, taxable at special rates. IRS Publication 544, Sales and Other Dispositions of Property, explains the rules regarding the taxation and reporting of gains and losses on the sale of personal, investment, and business property.
Selling Your Home
If you sell your home at a gain, you are generally not subject to any federal income tax on the gain up to $250,000 ($500,000 if you are married filing jointly). To qualify for this exclusion, you must have owned the home and lived in it as your main home for at least two years. For more information, you can refer to IRS Publication 523, Selling Your Home.
Job Hunting Expenses
You may be able to claim a tax deduction for certain expenses you incur while you are looking for a new job. And, you can deduct job hunting expenses even if you do not get the job. Deductible expenses include employment and outplacement agency fees, and travel expenses for job search and interviews. Job hunting expenses are a miscellaneous itemized deduction subject to the 2% of adjusted gross income limit. So you would be able to claim this deduction only if you itemize deductions rather than taking the standard deduction. To itemize deductions, you must use Form 1040 (not 1040A or 1040EZ) and complete Schedule A. More information on job hunting expenses is available in IRS Publication 529, Miscellaneous Deductions.
When you are unemployed, you may not be covered by health insurance, or you may have to pay for your own health insurance. If you had not previously been able to itemize deductions, you may be able to itemize when you are unemployed. You may have more deductible medical expenses (including health insurance), and also, your adjusted gross income may be lower, so your medical expenses could potentially exceed the 7.5% of adjusted gross income limit for itemizing. You should keep track of all your medical expenses so that if you are able to itemize, you will have the necessary supporting records.
Other itemized deductions to keep in mind, and to keep records of, in case you are able to itemize, include state and local income or sales taxes, real estate and property taxes, interest on a home mortgage, charitable contributions, casualty and theft losses, and any un-reimbursed job-related expenses you may have had while you were working. Job-hunting expenses, as discussed above, are also a miscellaneous itemized deduction.
Child and Dependent Care Credit
If you incur expenses to pay someone to take care of your child or other dependent in your home, or pay for a daycare facility while you look for work, you may be entitled to the credit for child and dependent care expenses. The person receiving the care must be your child under age 13, or your spouse or dependent who is unable to care for him or herself. You must keep up a home that you live in with the qualifying child or dependent, and you must have earned income for the year. And the person you pay to provide the services cannot be someone you could claim as a dependent on your tax return. But you can pay your child to provide these services, provided he or she is at least 19 years of age and is not claimed as your dependent.
The credit can be up to 35% of your qualifying expenses. This credit is claimed by filing Form 2441, Child and Dependent Care Expenses.
When you are unemployed, you may decide to take courses to update or improve your skills, or you may enroll in a degree program. There are tax benefits available for education expenses. These include the tuition and fees deduction, which can reduce your adjusted gross income subject to tax, and the Hope and lifetime learning credits, which directly reduce your taxes. You can find more information in IRS Publication 970, Tax Benefits for Education.
If you move to a new location in order to accept another job, or work self-employed in your own trade or business, you may be able to deduct your moving expenses. You will need to meet what are referred to as the time and distance tests. Your move must be closely related in time to the start of your new job or the start of work in your own trade or business, and you must have moved at least 50 miles. Moving expenses are an adjustment to gross income, so you do not have to itemize in order to claim the moving expense deduction. You will need to complete Form 3903 to claim the deduction for moving expenses. See IRS Publication 521, Moving Expenses, for more information.
Starting a Business
After you leave a job, you may decide to go into business for yourself. IRS Publication 334, Tax Guide for Small Businesses, provides useful information regarding the tax aspects of starting up a small business.
You can set up your business as a sole proprietorship, partnership or corporation. There are various factors to be taken into consideration in deciding which structure to use for your business. Some of the more important factors include ownership of the business, legal liability for business debts, the type of financing you intend to use, and the level of control you want to maintain over decision-making. A sole proprietorship is the easiest form to set up. You basically have a sole proprietorship when you start doing business. As a sole proprietor, you would report your business income and expenses on Schedule C or C-EZ, and attach it to your Form 1040 when you file your annual income tax return.
If you have employees working for you, you will be responsible for withholding and paying employee payroll taxes, including social security and Medicare tax, and federal income tax. You will also be responsible for federal and state unemployment taxes. Employment taxes are reported and paid using Form 941, Employer’s Quarterly Federal Tax Return, and Form 940, Employer’s Annual Federal Unemployment Tax Return. See IRS Publication 15, Circular E, Employer’s Tax Guide for more information.
You should keep separate, complete and accurate records of all your business income and expenses, in order to correctly prepare your tax return and also to properly manage your business.
Working From Home
If you work from home, either part-time for an employer, or in your own trade or business, you may be able to take a tax deduction for business use of your home. To qualify, you must use a certain part of your home exclusively and regularly for your trade or business. And the business part of your home must be your principal place of business, a place where you meet or deal with customers, clients, or patients, or it could be a separate structure, not attached to your home (such as a garage) that you use in connection with your business. Your home office can qualify as your principal place of business if you use it exclusively and regularly for managing your business, or if you do not have any other fixed location where you carry out those activities.
To claim this deduction, you must first complete Form 8829, Expenses for Business Use of Your Home. If you work at home for an employer, these expenses would be taken as a miscellaneous itemized deduction. If you are self-employed, these expenses are reported on Schedule C, Profit or Loss from Business.
As a self-employed individual, you will be subject to the self-employment tax, which is the equivalent of the social security and Medicare tax. This tax is calculated on Schedule SE, Self-Employment Tax, which must be filed with your annual income tax return. You are entitled to take a deduction for one-half of the self employment tax on Form 1040.
The self-employment tax must be paid quarterly, together with any estimated income tax payments you need to make when you are self employed, as described below. For more information on the self-employment tax, see IRS Publication 533, Self-Employment Tax.
Estimated Tax Payments
If you go into business for yourself, or have other income on which federal income tax is not withheld, you may need to make estimated tax payments during the year. The general rule is that you must make estimated payments if you expect to owe taxes of $1,000 or more when you file your annual income return, or you expect that the tax withheld from your pay or from other amounts you receive during the year (such as the 10% withholding on unemployment compensation) will be less than 90% of the total tax you expect to report when you file your return for this year, or 100% of the total tax you reported on your return for last year. You will probably need to estimate your expected income and tax during the year, to see whether you need to make estimated payments.
.Estimated payments (including the self-employment tax) are made quarterly using Form 1040-ES. The due dates for estimated quarterly payments are April 15th, June 15th, September 15th, and January 15th. You do not have to start making estimated payments until you have income that is subject to estimated tax. For example, if you leave your job in the first half of the year, and start generating self-employment income in the third quarter, you would probably make estimated payments starting with the payment due on September 15th. See IRS Publication 505 for more information on estimated tax payments.
Starting a New Job and Filling Out A New W-4
If you start working for a new employer, you will need to fill out a new Form W-4 for withholding tax purposes. This may be a good opportunity to adjust your withholding allowances if you found that either too much or too little tax was being withheld from your pay in your prior job.
If You Owe Taxes and are Unable to Pay Them
If it turns out that you owe tax when you prepare your tax return, and you are unable to pay the tax, you should contact the IRS. It may be possible to work out an installment payment plan.