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, an information provider on taxes and other business issues. In fact, you — and the IRS — should get a 1099-G detailing how much you received in unemployment.

But there’s one bit of relief in this area on 2009 tax returns. The American Recovery and Reinvestment Act that became law last February exempts the first $2,400 in unemployment benefits from federal taxation.

Any unemployment in excess of that, however, is still taxable. And unless the worker requests it, states don’t have to take out withholding from unemployment checks. 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.

That means 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 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, or IRA, 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.

If a person has been fortunate enough to receive a severance package that includes several months’ worth of salary, that’s also considered taxable income. The decision to make at that point would be whether to take the money in a lump sum or a payout over time.

Annual inflation adjustments of the tax brackets could provide some tax relief if you decide to take an extended payout, assuming the company will be around that long. The other issue that comes into play is a person’s own spending habits. Some people would take a lump sum payment of six months’ worth of salary and blow it in a week; others would have no problem making it stretch for a year.

Meanwhile, there are some tax benefits that workers can take advantage of while they’re out of work and looking for a new job. Job-search services, such as resume preparation or travel expenses to an interview, may be deductible for people who file itemized returns.

Any educational expenses related to a person’s line of work also are deductible.

That means that if a person takes some classes to keep his skills up to date, that’s deductible. If they use a layoff as a springboard to launch a new career, courses related to the new field can’t be written off. Once a person gets a new job, if it involves moving, those expenses could be deductible, too.

Don’t forget about health benefits

While laid-off workers are setting aside money to pay their taxes, they also need to keep one other payment current — their medical insurance.

“Insurance is something people don’t think about,” Moore says. “If it lapses, it’s a huge problem.”

It can be particularly harmful if a family member has a pre-existing condition.

For that reason, the experts recommend biting the bullet and taking the coverage offered by their former employer through COBRA. It’s expensive because the individual is paying what the coverage previously cost them and their former employer, plus 2 percent. But it provides the necessary continuity to maintain a person’s eligibility for medical insurance when they get a new job.

Workers have 60 days to decide whether or not to accept COBRA coverage, Sommer says. They can even wait until they actually have a claim to decide to take it. “You don’t have to decide the day you lose your job,” he says. “If you need it and decide you want it, you can get it.” With the 60-day window, Moore says that a lot of people only wind up paying one COBRA premium before they have a new job with benefits. For the peace of mind it offers and the potential problems it heads off, she says, it’s worth the expense. Or, if a worker is young and healthy, Sommer says, he also might look into getting an individual policy or coverage through a professional or trade association. One way or another, though, it’s critical not to let the coverage lapse.

Finally, come tax time, it will be important for workers to hang on to their last pay stubs. If the company goes under, it might be tough to get a W-2. With or without it, the income still has to be reported. Moore recommends attaching a copy of the pay stub to the return, with a note stating that a W-2 wasn’t received and that the tax obligation has been based on the information from the pay stub.

That’s usually enough to get the IRS to pay a call to their former employer, which should give laid-off workers at least something to smile about.

<< Back to Bankrate’s 2010 Tax guide table of contents.

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