Whole Ball of Tax 2003
OUT OF WORK? WHEN IT COMES TO TAXES, INCOME IS
INCOME
WHETHER FROM A JOB OR UNEMPLOYMENT BENEFITS
Navigating Unemployment, Retirement Plans, Health
Care, the Job Search…
CCH Outlines the Taxes of Being Out of Work
(RIVERWOODS, ILL., January 2003) For many Americans, 2002 was no
better than 2001 as more layoffs contributed to continued high
unemployment rates and the economy showed little promise of
rebounding. For the millions who found themselves unemployed – many
for the first time – this means understanding not only the maze of
unemployment benefits, but the tax issues that arise when you’re out
of work, particularly if you’re out of work over the long term,
according to CCH INCORPORATED (CCH), a leading provider of tax,
pension, payroll and employment law information and services.
"With the economy in a holding pattern, it’s taking
individuals a lot longer to find new jobs," said Barbara Moore,
an attorney and unemployment law analyst with CCH. "They may not
only have exhausted their savings, but as more time passes and they
remain out of work, they also may be nearing the end of their
unemployment benefits – despite the additional time offered by the
temporary federal extension passed by Congress in early 2002."
The long-term unemployed face a whole set of new issues, not just
how to make sure they set aside enough to pay their taxes, but
understanding the options and tax penalties for tapping retirement
accounts to pay for basic expenses, how to deal with health insurance
costs and the costs of searching for a job as well as the consequences
of taking part-time work to supplement unemployment. Below, CCH
examines each.
First in Line: IRS and State Treasury
While each state government administers unemployment benefits in
its state, it’s businesses that pay into the states’ unemployment
trust funds. As a result, when you receive unemployment benefits, you’re
responsible for paying the taxes on those benefits, based on your
overall income. For those who lost good-paying jobs late in the year,
it could mean that despite being out of work, they could still find
themselves in the same higher tax bracket as they’d been in when
employed.
"If you had an annual salary of $100,000 a year and were laid
off during the fourth quarter of 2002, after receiving $80,000 of that
salary, there’s a good chance, you’ll still be in the 30-percent
tax bracket as a single filer, assuming your taxable income is above
$67,700," said Moore. "Moreover, any unemployment benefits
you receive will be taxed at that 30-percent rate. It may not seem
fair, given that you’re not working, but the income tax rate is
based not on what you earned but on your total income, whether from
salary or unemployment benefits."
For those who have been unemployed for a longer period of time, it’s
likely they now may find themselves in a lower tax bracket. But, they
too are required to report all income and pay taxes on that overall
income level.
For example, say you live in Seattle and had an annual salary of
$90,000 when you lost your job at the beginning of January 2002. You
had severance until March 1, at which time you went on unemployment.
So, from your income while you were employed and your severance pay
you earned $15,000 during the first two months of the year.
You went on unemployment for the rest of they year – or 44 weeks
– using the 30 weeks unemployment benefits provided by the state of
Washington, as well as the full 13 weeks of temporary extended
unemployment offered under the federal Job Creation and Workers
Assistance Act of 2002. You then used one week of the 13 weeks of
unemployment provided under the Federal-State Extended Benefits
Program.
Your unemployment benefits through December 31, 2002, were $496 a
week for the 44 weeks, or $21,824 for the year. As a result, your
income in former wages and unemployment benefits totaled $36,824 for
the year.
For the first two months of the year, while you were employed or
receiving severance, 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.
In the above example, assuming you're single with no dependents,
this is the only income you earned and you had only standard
deductions, you moved from the 30-percent tax bracket to the
27-percent bracket. Assuming your employer did withhold at the
30-percent rate, it’s likely you don’t have to hand over a flat 27
percent of your unemployment benefits for federal income tax, but you
still could potentially owe a few thousand dollars in 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 did 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. If you did not, you
may be subject to a late payment penalty as well.
Healthcare Deductions and Payment Options
With the rising costs of health care, one of the largest new costs
for unemployed individuals can be paying the healthcare premium,
previously covered by their employers.
Most employees who are laid off can continue healthcare coverage
through their former employer’s group healthcare plan for up to 18
months under COBRA (Consolidated Omnibus Budget Reconciliation Act of
1985).
Footing the entire bill for healthcare insurance as well as an
additional 2-percent administrative fee your former employer can tack
on to COBRA may seem steep. However, enrolling in COBRA may be the
best option if you have no other alternatives, such as gaining
coverage under your spouse’s insurance plan, as individual health
insurance is generally even more costly than COBRA.
"It’s important that you make your decision relatively
quickly," said Moore. "If you go without health insurance
for as little as 60 days, that’s considered a break in coverage,
which can trigger a pre-existing clause in a future insurance policy
should you currently have a pre-exisitng condition or injure yourself
resulting in a pre-existing condition while uninsured."
For those who elected to take COBRA but are now nearing the end of
the 18- month program, the decision then becomes whether to enroll in
an individual health insurance plan or risk going without insurance.
"While health insurance can seem like a discretionary cost
when you’re unemployed and facing a host of other expenses, you
really should try to keep some sort of coverage," said Moore.
"Even if it’s a policy that has a very large deductible. You’d
at least have coverage if something catastrophic occurred, and if you
have a pre-existing condition, you’d be protected from triggering
this in a future policy."
Whether you are on COBRA or an individual health insurance plan
while you’re unemployed, part of the cost might qualify as an
itemized deduction. Additionally, you may be able to tap your
retirement account to cover the insurance cost.
Tapping into Retirement While Avoiding Retirement Plan Penalties
Understanding what options you have for your retirement plan after
losing your job can mean the difference between preserving your
retirement savings or seeing it dwindle from penalties and taxes. For
those who think tapping into their retirement savings is the only way
to survive their time out of work, additional planning is needed.
When you leave your employer, the options for your retirement plan
are: choosing to keep the existing plan, assuming you meet the
requirements to do so; requesting a direct rollover to another plan;
or cashing out of the plan all together. Each has its own set of tax
consequences.
If you have a 401(k) or other qualified plan with your former
employer that’s valued at more than $5,000, you can leave it there,
and it will continue to grow tax-deferred. This may be worth
considering for those who think they’ll need to access their
retirement funds while unemployed as most 401(k) plans offer a loan
option to participants. Taking a loan rather than taking a
distribution, which generally is subject to the 10-percent early
withdrawal penalty, helps preserve retirement funds.
However, you do have to pay back your 401(k) with interest based on
a strict payment plan. If you fail to do so, then it will be
considered a distribution and you will be subject to the withdrawal
penalty. Rather than taking a loan from his or her 401(k), therefore,
an unemployed person may wish to consider other options that may be
available under the plan. For example, some offer certain penalty-free
hardship distributions. The bottom line is you should check the terms
of the plan first.
If you have less than $5,000 in the plan or simply want to move out
of your former employer’s plan into another qualified plan you need
to request a direct rollover. 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) plan, 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, if you rolled the funds over to an IRA and you later
decide you need to tap into your retirement to tide you over, you have
far fewer options than provided by a 401(k) plan. For example, a
401(k) plan may allow you to take loans for a number of unspecified
reasons. However, penalty-free withdrawals from an IRA are limited to
just a few specific purposes, including to pay for
"qualified" higher education expenses or "first-time
homebuyer" expenses.
In addition, there’s no penalty if an IRA withdrawal is used to
cover health insurance premiums while you’re unemployed and meet
certain qualifications. These qualifications include that: the
withdrawals must not exceed the amount paid during the year for
medical insurance for you, your spouse, and dependents; you must have
received unemployment compensation for 12 consecutive weeks under
federal or state law; and the distribution must be made during any tax
year in which you receive unemployment compensation or during the next
tax year.
The exception to the 10-percent penalty does not apply after you’re
back in the workforce if you’ve been re-employed for at least 60
days after initial separation from service.
The final option is to take possession of your retirement benefit.
If you do this and you’re under age 59½, you will be hit with a
10-percent penalty for early withdrawal if you do not roll over 100
percent of the value of the account into another qualified plan within
60 days. If you’re intention is to roll it over into a qualified
plan, then the best alternative is to do so by requesting a direct
rollover and never taking possession. Taking possession is complicated
and you still run the risk of a penalty.
For example, when you request to take possession, 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 other 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.
However, if you can’t come up with the cash to cover this and
simply rollover the 80 percent you have, the remaining 20 percent of
your former retirement plan becomes fully taxable. As a result you
will likely have to pay the 10-percent penalty for early withdrawal on
that 20 percent.
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.
"Tapping into retirement funds may be the only option for
someone who has been unemployed for a while, but it really should be
planned as best as possible," said Moore. "One of the worst
things you can do is to panic and cash out. There are other ways of
getting to the funds that have far fewer ramifications and are far
more cost-effective."
Your Job Search is Deductible
The longer you’re out of work, the more your job search is likely
to cost. So keeping track of your expenses and taking the eligible
deductions can provide some welcome tax savings. Among the expenses
you can deduct are resume printing costs, postage, long-distance calls
and faxes; travel expenses, including air, taxi, rail as well as
mileage and tolls; and lodging expenses for out-of-town interviews.
However, you can only claim the expenses if you are seeking a position
in the same trade or business.
Part-time Work or Becoming Your Own Boss Can Be Taxing and Risky
Those who are unemployed and decide to do some consulting or find
part-time work to help supplement their income while they look for
another job need to be cautious of the tax consequences as well as the
risk these situations can pose to unemployment benefits.
If you decided to take a part-time job, you need to be aware of how
much income you can make from working before your unemployment
benefits are reduced or eliminated.
If you opt to be your own boss, taking on some consulting work
temporarily, for example, you are officially considered self-employed.
This means you are required not only to pay income tax but, you also
must pay into Social Security and Medicare under the Self-Employment
Contributions Act (SECA) if you made more than $400 in income while
self-employed. This tax is basically the self-employed individual’s
version of FICA. As an employee, your FICA tax was only 7.65 percent
with your employer paying another 7.65 percent. As a self-employed
individual, you are now required to pay the entire 15.3-percent SECA
tax.
Whatever type of temporary work you consider, you have to be very
aware of your state’s unemployment benefit laws and be willing to do
the math, or risk losing your benefits. For example, if your
consulting is slightly more successful than you thought or you didn’t
keep track of what you were bringing in from your part-time job, you
could make yourself entirely ineligible for unemployment.
You can’t then stop consulting or quit your part-time job and
become eligible again for the same unemployment benefits you had been
collecting. Rather, in the instance of taking on part-time work, your
future unemployment benefits would be based on your part-time wages.
And, if you stop consulting, as a self-employed individual, you’re
not eligible for any unemployment benefits.
However, if you are seriously thinking of making a go of being
self-employed, there are some added tax and assistance benefits you
may be eligible for.
"Some individuals who had thought about heading out on their
own but had been reluctant to leave good jobs now see forced layoffs
as their opportunity to give being their own boss a try," said
Moore.
These budding entrepreneurs may want to see if their state offers
Self-Employment Assistance programs. These programs allow you to take
courses sponsored or approved by the state or receiving business
counseling. During this, you get 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.
The self-employed can take advantage of a variety of deductions as
well. For example, 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; business-related
legal and professional services and business travel expenses.
Additionally, you can take depreciation on office equipment and may be
eligible for certain small business credits. The self-employed also
can deduct health insurance costs above the line – 70 percent in
2002 and 100 percent in 2003.
If you were searching for a job, and consulting on the side or
later decided to become a full-time entrepreneur, you can deduct the
eligible expenses of your job search as well as the expenses related
to your business.
About CCH INCORPORATED
CCH INCORPORATED, headquartered in Riverwoods, Ill., was
founded in 1913 and has served four generations of business
professionals and their clients. The company produces more than 700
electronic and print products for the tax, legal, securities,
insurance, 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.
The CCH tax and accounting destination site can be accessed at tax.cchgroup.com.
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