Making the Most of Your Taxes for the Growing Legions of Unemployed – Part 2

As a follow up to the entry I posted yesterday, here are some ways to make the most of your taxes if you are one of the millions currently struggling with unemployment.

First of all, you can probably expect a larger refund. Taxes are withheld from wage earners based on the assumption of continued employment and continued income throughout the year. Abruptly losing your source of income means you probably had taxes overwithheld from your previous pay, expecting you would end up in a higher tax bracket. When you file, you will correct that assumption and enjoy a little extra money coming your way in the form of a refund.

If you received public assistance, like food stamps or WIC, or if someone gave you money to help you out, those forms of income are not taxable. You can receive up to $13,000 a year in gifts from a single source, tax-free. Unfortunately, gifts to an individual cannot be deducted by the giver as a charitable contribution.

Many unemployed people do some freelance work to gain some income. While this means you have to pay self-employment taxes on that income (including Medicare and Social Security taxes), it also means you might be able to deduct expenses for the business. So, be sure you keep good records (and receipts!) and deduct everything to which you are entitled. You can also take advantage of the home office deduction, which is available for both owners and renters, so long as there is a dedicated space used regularly and exclusively for business, and it is the principal place of your business. This could include deducting mortgage interest, insurance, utilities, repairs and depreciation.

Since your income was cut-off, your are probably going to have a lower adjusted gross income (AGI) than in years past. Thus, you may be able to deduct medical expenses, student loan interest, and other miscellaneous deductions that you may have been ineligible to claim in the past. For example, you can usually only deduct medical expenses that exceed 7.5% of your AGI, making many employed people and those with employer provided health care ineligible. However, with a lower AGI, more of these expenses will become deductible. Also, remember that if you are paying COBRA fees to keep your medical insurance, you can deduct those fees as part of the medical deduction.

You may be able to undo your IRA contributions from earlier in the year. This means you can withdraw the amount you put in, including interest and dividends without tax hits. The only trick here is that you can not then also claim a deduction for those contributions, and you must still include any income you earned from the contribution.

This could be the perfect opportunity to dump some loser stocks and use capital losses to your advantage. Generally capital losses locked in by selling stocks are used to negate capital gains. However, if you have no capital gains, or have more losses than gains, you can use up to $3,000 of that loss to negate ordinary income. You can also carry the remainder of the loss forward into future years until you deplete the entire loss. And of course, one of the best parts is that by selling the stocks, you get an instant cash infusion.

Many tax professionals are offering free or low cost tax preparation for people who are having hardships or unemployed. Check around and find out if there are any reputable tax-preparers doing so in your local area. And the IRS is also offering free electronic tax filing and preparation for taxpayers with an adjusted gross income under $56,000 through the Free File program. Prefer in person help? The IRS offers Low Income Taxpayer Clinics. These clinics are run through independent organizations providing low-income taxpayers with representation in federal tax controversies with th4e IRS for free, or for a nominal charge. The clinics also offer tax education and outreach for taxpayers when English is their second language. If those options don’t work for you, the IRS offers free tax preparation help nationwide form IRS trained volunteers. The Volunteer Income Tax Assistance program is designed to help low income taxpayers, and the Tax Counseling for the Elderly program is designed to assist taxpayers over 60 years old with their returns.

While it doesn’t help you this year, there will be a number of tax breaks and unemployment help available for 2009. From $2,400 tax free in unemployment compensation, increased unemployment benefits, and prolonged eligibility periods, the American Recovery and Reinvestment Act (AKA the Stimulus Package) may help ease the burdens of families struggling with unemployment. Small comfort for those who needed help last year, but hopefully some of the tips in this post can help you make the most of a bad situation.