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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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For more information on the president's 2003 Economic Growth Tax Plan, please visit,
 
2003 Bush Tax Plan

The 2003 Whole Ball of Tax also is available in print. If you would like to request the print version, please contact:

 
Leslie Bonacum
(847) 267-7153
 
mediahelp@cch.com
 
Neil Allen
(847) 267-2179
allenn@cch.com

   


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