Monday, April 20, 2009

How to Avoid Owing Back Taxes on Unemployment Benefits

At the end of last week I posted an entry on the Tax Relief Blog with advice on how to avoid owing back taxes on unemployment. Check out the text of the entry below.

Taxable Income

Believe it or not, the money you receive from unemployment benefits IS taxable income. Which means you are going to owe both federal and state income taxes on it (if your state has an income tax). At the end of the year you should expect to receive IRS Form 1099-G, which will show the total amount you received in benefits.

Withheld Taxes

When collecting unemployment benefits you are not required to have any taxes withheld, but it is an available an option, and a good one at that! By having income taxes automatically withheld from your checks, you can avoid having to write a big check come next April. When you apply for unemployment, you can select to have a 10% federal income tax withheld, as well as a state income tax (the exact percent will vary per state). It is also highly recommended that you take a thorough look at your first unemployment check stub to make sure that the correct taxes have been withheld.

First $2,400 is Tax Free

Although you do have to pay income taxes on unemployment benefits, in 2009 you will not have to pay taxes on the first $2,400 in unemployment benefits you receive. Confused yet? Well, it only gets more complicated. The change is part of the new 2009 American Recovery and Reinvestment Act and only affects the 2009 tax year. All benefits from the year 2008 and before are fully taxable. For more information, check out this IRS news release on the topic.

Severance Pay

Do not forget that any severance payment you might receive is also considered taxable income. This includes any one-time payments, as well as payouts for accumulated vacation or sick leave benefits. It is considered regular income, and should be taxed at your appropriate tax rate.

Estimated Payments

If for any reason you do not choose to have taxes withheld on your unemployment, you should still consider making an estimated quarterly payment. It can be somewhat confusing to calculate and file these payments, but it beats getting hit with an underpayment penalty at tax time.

Check State Laws

Do not forget that your state is also going to tax your unemployment benefits! If your state has an income tax, then you will likely have to pay income taxes on your unemployment benefits. However, every state is different so before making any decisions, check out your state’s website, or ask a professional for help.

Continuous Job Hunt

One of best ways to avoid tax problems is to build up allowable deductions and credits. Luckily for the unemployed, the tax code provides a cornucopia of tax savings for job hunters. From education deductions and credits, to the job-hunting expenses deduction, to the moving deduction, the code is set up to help you avoid owing taxes while unemployed so long as you are actively seeking employment. In addition, most states provide similar deductions and credits. So, please do some research—you can start by checking out my blog entry on the topic here —or meet with a tax professional to find out how Uncle Sam is willing to help you on your job hunt.

Get Professional Help

Just because you are unemployed does not mean the IRS is going to let you get away without filing a return. In addition, your return is certainly going to look a little different now that you are receiving unemployment income. Having professional guidance through this financial change may prevent you from making some major mistakes on your tax return.

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