Talk about adding insult to injury. As if it weren't bad enough to be laid off from a job, workers who apply for unemployment compensation might be shocked to learn that they have to pay federal income tax on those benefits.
"It's a wage payment; you have to pay taxes on wages," says Barbara Moore, an attorney and unemployment law analyst with CCH Inc., an information provider on taxes and other business issues.
Adding to the problem, unless the worker requests it, states don't have to take out withholding from unemployment checks. And when a person is trying to figure out how to pay next month's mortgage or rent, paying the taxes on those benefits tends to drop down the priority list.
But workers who receive long-term benefits -- most states permit workers to collect benefits from 26 to 30 weeks and often grant extensions -- could be looking at having a large tax payment due on next year's return.
"The thought process is, 'Give me all I can get right now, and I'll worry about my taxes later,'" says Michael Eisenberg, a CPA and personal financial specialist in California.
Depending on the tax bracket, that could mean owing the IRS a few thousand dollars.
According to Moore, if individuals don't opt to have the state take out withholding, they're responsible for figuring it out on their own and making quarterly payments, just as if they were self-employed.
Speaking of self-employed, that's another surprise many people encounter after they're laid off, Moore says. They use that event as an opportunity to go into business for themselves or do some short-term consulting while they're looking for another job. But what they don't realize is that now they're responsible for paying self-employment tax, which means they have to pay both the employee's and employer's portion of FICA.
Benefits and tax issues
That's not all. There are several tax and benefit-related issues that workers need to address when they lose their jobs. Perhaps the most important is what to do with their retirement account. If they like how the money is invested, they may consider leaving the account where it is, but Eisenberg says he doesn't recommend it. With today's mobility, it can be easy for a plan to lose track of a worker's current address.The easiest option is to roll the funds over into an individual retirement account with a bank or a brokerage firm. It's a simple matter to transfer the funds directly from the existing account into the new one. That's a far better option than getting a check for the lump sum. If that happens, the worker has 60 days to deposit it in a new IRA or face taxes and early withdrawal penalties, and there's a lot of temptation to live off that money instead of using it for its intended purpose.
"You don't want to touch the money," says David Sommer, associate professor of risk management and insurance at the University of Georgia's Terry College of Business. "Once you have the money, it's hard to have the discipline to roll it over. Have it directly transferred." In other words, make sure it's a trustee-to-trustee transfer. Another important thing to remember is if a person takes out a loan against a 401(k), it normally has to be paid off before leaving the company to avoid paying taxes and penalties.