Financial Resource Center


Tough Times Series: The Tax Consequences of Unemployment

by Danielle Dresden / November 13th, 2010

You've probably heard there's nothing certain but death and taxes. The old saying holds true, even in an uncertain economy. Even when you lose your job, you still have to pay taxes. As of late summer 2010, there were 14.6 million people out of work in the U.S., making for a national unemployment rate of 9.5%, according to the U.S. Labor Department.

Your tax responsibilities

The hard truth is that unemployment compensation is taxable. So is severance pay and payment for accumulated sick leave. Payments for unused vacation time are taxable as well. Under the American Recovery and Reinvestment Act (ARRA)—or the stimulus package, as it's more commonly known—the first $2,400 of unemployment compensation individuals received in 2009 were tax-exempt. But that benefit has expired. "At this point, the $2,400 exemption for unemployment compensation applies to income for 2009," says Christopher Miller, media relations spokesperson with the Internal Revenue Service (IRS). "We cannot speculate on what may or may not occur in the future." Not everything is taxable. If you're eligible for food stamps, those aren't taxed. You usually don't pay taxes on gifts, unless they produce income (such as interest, dividends, or rent). Also, note that we're only discussing federal taxes, not state taxes. Some states tax unemployment compensation and some don't. Check local regulations to see how they affect you.

Plan ahead

If you've recently been laid off, next year's taxes might seem like the least of your worries. Still, plan ahead so you don't face a jaw-dropping bill when you file. You have two basic options: Arrange for federal withholding, or make estimated tax payments.
Plan ahead so you don't face a jaw-dropping tax bill when you file.
Choosing withholding gets the federal government to do what your employer did: take cash out of your checks to cover taxes. But you can't vary the rate—government withholding is a flat 10%. Sign up for withholding by filling out Form W-4V. You also can estimate your tax with Form 1040-ES and make quarterly payments. Just be sure you make those payments, and account for all of your income.

Negotiate with the IRS

If you think you won't be able to pay your taxes, call the IRS at 800-829-1040 to discuss your options. The agency may be able to offer you:
  • A short-term extension to pay;
  • An installment agreement (using Form 9465);
  • An offer in compromise; or
  • A penalty waiver, in some cases.
You still will need to file on time, and the IRS can't waive interest charges on unpaid bills.

Tax benefits of unemployment

Using unemployment tax benefits takes work. You'll need to file Form 1040-A—the "long form"—and itemize expenses. That effort lets you deduct these job-hunting expenses:
  • Employment agency fees—These could count as income if an employer reimburses you.
  • Phone calls—You can deduct local and long-distance calls to job contacts.
    Going back to school can make you eligible for tax credits or deductions.
  • Résumé services—This includes the cost of writing, printing, and mailing résumés.
  • Travel—If you're hitting the road for a job interview or search, you can deduct related expenses.
These deductions only apply if you're looking for work in your current occupation. If you're switching fields, are long-term unemployed, or if this is your first time at the job-hunt rodeo, they don't.

Health insurance and unemployment

People laid off through no fault of their own can purchase health insurance at group rates through the Consolidated Omnibus Budget Reconciliation Act (COBRA) for up to 18 months, or even longer if you have a qualifying disability. Your premiums will be lower than they would be if you bought insurance as an individual, but they still add up. If you were laid off between Sept. 1, 2008, and May 31, 2010, you may be eligible for a federal subsidy covering 65% of your COBRA payments for 15 months. However, this benefit expired for people laid off after June 1, 2010. Health-insurance premiums still are deductible—as long as you file Schedule A and your total unreimbursed medical expenses are more than 7.5% of your adjusted gross income. You also can use your IRA (individual retirement account) to cover health-insurance costs for yourself, your spouse, or your dependents, even if you're not age 59½. If you've been unemployed for 12 weeks or more, you won't face penalties.
You can deduct some job-hunting expenses.

Get credit for credits

Going back to school, or taking courses to become more employable, can make you eligible for tax credits or deductions. See if you meet the qualifications for these credits: These benefits only apply if you're studying within your field. For a complete listing of educational benefits, visit the IRS Tax Benefits for Education Information Center.

Worth a second look

If you're earning a lot less this year than you earned in the past, you may qualify for these tax credits and deductions, which are phased out for people with higher incomes: Just because taxes are one of the few things you can count on in uncertain times doesn't mean you should pay more than you have to. Make full use of the benefits due to you, and look forward to the time you can leave them behind.
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