If You Lose Your Job, You Still Have To Pay Taxes, But Deductions Can Ease The Bite

From Unemployment Benefits to Taking a New Job, CCH Looks at the Tax Consequences of Being Out of Work

(RIVERWOODS, ILL., January 25, 2002) - After years of record-high employment rates, the economy took a downward turn in 2001 with well over a million jobs eliminated. For the newly unemployed, this sets up an entirely new set of tax issues and rules when it comes to preparing 2001 tax returns and planning for 2002, according to CCH INCORPORATED (CCH), a leading provider of tax and employment law information and services.

"In the late 1990s with record-low unemployment and most businesses booming, the employee was in the driver’s seat. There were plenty of good jobs to choose from and their retirement plans were growing at record rates," said Barbara Moore, an attorney and unemployment law analyst with CCH. "But the economic climate in 2001 was entirely different. Now, rather than figuring out how much earlier they may be able to retire, many employees were facing the immediate threat of being laid off."

For those employees who lost their jobs during the year, unemployment benefits, health insurance costs, retirement plan decisions and the costs of searching for new jobs all became new concerns, each with their own tax consequences.

Down But Not Out When it Comes to Paying Taxes

One common misconception is that unemployment benefits are tax-free. However, that’s not the case, and the government expects you to figure out and pay what you owe in taxes based on your overall income for the year, including what you receive in unemployment.

Therefore, if you had a good-paying job, which you lost in mid-2001 and began collecting unemployment in the last half of the year, your income from unemployment would be taxed based on your overall income for the year.

"In the eyes of the IRS, income is income. Whether it comes from a paycheck or unemployment benefits has no bearing on your tax obligation," said Moore. "You are required to report all income and then pay taxes based on that overall income level."

As a result, individuals could find themselves in the higher tax brackets, even if they were unemployed at the end of 2001. For example, say you are single, worked in New York and your salary was $96,000 a year. You lost your job on September 1, 2001, after having made $64,000 for the first eight months of the year.

You then go on unemployment beginning October 1, 2001. Your unemployment benefits through December 31, 2001, are $405 a week for 13 weeks, or $5,265 for the year.

Despite being jobless, this would mean that your income in former wages and unemployment benefits totaled $69,265 for the year, keeping you in the 30-percent tax bracket.

For the first eight months of the year, while you were employed, your employer withheld for income tax as well as for FICA (Federal Insurance Contributions Act) tax. Once you began collecting unemployment, you no longer have to pay FICA, but you do have to pay income tax. When you first begin receiving unemployment benefits, your state should inform you of this and give you the option to have the state withhold from your benefits for both state and federal income tax. If you do not take your state up on the withholding option, you are required to figure out what you owe and file quarterly estimated taxes with the IRS and your state treasury department.

Also, as estimated payments are required to be filed quarterly and you went on unemployment in October in the example above, your payment for fourth quarter estimated taxes would have been due on January 15, 2001. The IRS does allow an extension to January 31, 2001, but only if you file your entire 2001 tax return by that date.

For those employees who lost their jobs because their companies went under, one tricky issue may be that the former company is either slow in sending the employee his or her W-2 or they fail to do so. Individuals still must pay taxes, with or without this form. Therefore, if you don’t receive a W-2 for 2001 from your former employer, look at your last pay stub and calculate what you owe from this. You also should attach a note to your return indicating that your employer did not provide you with a W-2 and that you’re basing what you owe from your pay stub.

"This doesn’t get you off the hook if you owe more taxes. But, the IRS generally goes after your former employer to get the W-2 information," said Moore.

Capturing Healthcare Deductions

In addition to losing wages, one of the biggest issues for individuals who have lost their jobs is losing healthcare benefits.

When you’re laid off, you are generally eligible to continue healthcare coverage under COBRA (Consolidated Omnibus Budget Reconciliation Act of 1985) through your former employer’s group healthcare plan, and you can stay on this plan for 18 months.

But it’s not cheap. While you were employed, your employer may have picked up part or all of the cost of your healthcare insurance. But under COBRA, you’re now required to pay 100 percent of the premium, and your former employer can tack on an additional 2-percent administrative fee.

While this is costly, most experts recommend that you do enroll in COBRA if you have no other alternatives, such as gaining coverage under your spouse’s insurance plan. Individual health insurance is generally even more costly than COBRA and letting your health insurance lapse can be a risky proposition.

"If you go without health insurance for as little as 60 days, that’s considered a break in coverage," said Moore. "And if during that time, you become ill or get injured you may have a hard time getting insurance in the future if that illness triggers a pre-existing condition clause in your new employer’s health insurance plan."

Whether you elect COBRA or find a different health insurance plan to tide you over while you’re unemployed, part of the cost can be deducted.

Avoiding Taxes and Penalties on Your Retirement Plan

Properly planning what to do with your retirement plan when you lose or switch jobs can mean the difference between preserving your retirement savings or seeing it dwindle from penalties and taxes.

If you have a 401(k) or other qualified plan with your former employer, you have a few different options, but not all are created equally when it comes to taxes, according to CCH.

If you have more than $5,000 in a qualified retirement plan with your former employer, you can leave it there and it will continue to grow tax-deferred.

If you have less than $5,000 in the plan (which permits the plan to force distribution), or you simply want to cut ties with your former employer, another option is to request a direct rollover into another qualified plan. This must be done within 60 days after you are terminated or quit your job. The direct rollover could be into your new employer’s 401(k), for example, assuming you find a new job within the required 60-day rollover period, or it could be put into a traditional IRA. With this type of rollover, there are no tax obligations or penalties and your retirement savings continues to grow, tax-deferred, in the new plan.

However, penalties and taxes do kick in if you elect to take possession of your retirement benefit. In these instances, your former employer is required to withhold 20 percent of your retirement savings for taxes. You then have 60 days to roll your retirement plan over to an IRA or another qualified plan. But, you must deposit 100 percent of what had been in your former retirement plan into the new plan, meaning you have to find a way to make up the 20 percent your former employer withheld.

If you come up with the cash and do this, then there are no tax consequences or penalties and your former employer will release the remaining 20 percent that had been withheld once you show proof that you made the rollover.

If you can’t come up with the cash, however, and simply rollover the 80 percent you have, the remaining 20 percent of your former retirement plan becomes fully taxable, and, if you’re under 59, you may be hit with an additional 10-percent penalty for early withdrawal.

There are limited exceptions to these penalties. For example, if you’re 55 or older and laid off or you use the money for certain medical or health insurance expenses, you won’t be required to pay the 10-percent early withdrawal penalty.

"The general rule is that unless it’s completely unavoidable, you do not want to take possession of or take any distributions from your qualified retirement plan until you reach the required age," said Moore.

Tax Consequences of Consulting on the Side

Those who were laid off during 2001 and decided to do some consulting on the side to help supplement their income while they looked for another job have an additional set of tax issues to face in filing their 2001 income taxes.

Even if you’re only consulting temporarily, you are officially considered self-employed. Then you are required not only to pay income tax but, if you made more than $400 in income while self-employed, you also must pay into Social Security and Medicare under the Self-Employment Contributions Act (SECA). This tax is basically the self-employed individual’s version of FICA. However, as an employee, your FICA tax was only 7.65 percent with your employer kicking in another 7.65 percent. As a self-employed individual, you are now required to pay the entire 15.3-percent SECA tax.

"If you’re just thinking about doing a few small consulting projects, you really should crunch the numbers to see if it will be worth it," said Moore. "For example, you need to figure out how much income it will bring in versus how much you could lose in unemployment benefits, depending upon your state’s eligibility and benefit laws, and how much you may be obligated to pay in SECA tax."

However, if you are seriously thinking of making a go of being self-employed, some states now have Self-Employment Assistance programs. Under these programs, you take courses sponsored or approved by the state or receive business counseling. In return, while you are in the program, you can receive an allowance instead of regular unemployment benefits if you meet the requirements, and the state will not reduce your benefits based on the self-employment income you earned while enrolled in the program.

There are other tax breaks you will get if you are self-employed. For example, you can write off the "employer" portion of your employment taxes as a general business expense. Other legitimate expenses include: the costs of installing and using a second phone line if working from a home office; journals; dues for unions or professional associations; advertising and marketing expenses; gifts valued up to $25 to business associates; postage or package delivery and related insurance; and legal and professional services related to your business. You also can deduct travel expenses and take a standard mileage deduction for business use of your auto or start to depreciate it. Additionally, you can take depreciation on office equipment.

Tracking Expenses of Your Job Search

Another commonly overlooked set of tax breaks for the unemployed are the deductions available to offset the costs of their job search. The one catch: You can only claim the expenses if you are seeking a position in the same trade or business.

Among the expenses you can deduct are:

  • Printing costs for resumes
  • Postage
  • Long-distance phone calls and faxes
  • Fees paid to search firms
  • Travel expenses, including air, taxi, rail, mileage and tolls
  • Lodging expenses for out-of-town interviews

If the job you end up taking requires you to relocate, you also can deduct qualified moving expenses. Generally, these include the cost of packing and transporting household goods and personal effects, and of transporting you and your family from your former home (including lodging en route). To qualify for these deductions, the new job location must be at least 50 miles farther from your home than your former job location, and you must work full time for at least 39 weeks during the first 12 months after the move.

Take note, however, that expenses incurred in searching for a new residence at your new job location are not deductible unless you combine the search with an "interview" or meeting with your new employer.

"In a tight job market, where you could be facing an extended search and you have limited income coming in, these costs can really add up," said Moore. "So, it can definitely be worthwhile to take the time to keep track of and record these expenses."

Even if you are lucky and find an employer who offers a generous relocation package that pays your moving expenses, home closing or selling costs, house hunting trips and or other costs, use caution. These generous "benefits" (often totaling tens of thousands of dollars) are considered taxable income, according to the tax laws. Make sure your new employer "grosses up" the benefit, paying the taxes for you.

About CCH INCORPORATED

CCH INCORPORATED, headquartered in Riverwoods, Ill., was founded in 1913 and has served over four generations of business professionals and their clients. The company produces more than 700 electronic and print products for the tax, legal, securities, human resources, health care and small business markets. CCH is a wholly owned subsidiary of Wolters Kluwer North America. The CCH web site can be accessed at cch.com. The CCH Human Resources group web site can be accessed at hr.cch.com.

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