Tax breaks for the unemployed

Pay taxes on unemployment

First, the bad news. Unemployment compensation is taxable income. A few years ago, a small amount of unemployment benefits were exempted from taxation, but that tax break has expired.

You'll get a Form 1099-G that will tell you how much unemployment you must report on that year's tax return. If you opted not to have taxes withheld from unemployment payments or didn't make estimated tax payments on the amount, you'll likely owe the Internal Revenue Service.

Married couples have another option. If your spouse has a job, cover the unemployment taxes by having your husband or wife adjust his or her withholding to cover the taxes due on your benefits.

Check EITC eligibility

The earned income tax credit, or EITC, is a tax break for workers who don't make very much money. Because your overall earnings were reduced by your layoff, you now may be eligible for the EITC.

Unemployment benefits don't count toward EITC eligibility, but if you earned any other income during the year, you can use that amount to calculate a possible credit claim. Also, if you are married and your spouse is working, your loss of income may now make your combined earnings eligible for the credit.

Single taxpayers can claim the EITC, but the benefit is greater for workers with dependent children.

This tax credit also is refundable. This means if you don't owe any taxes, you'll be able to get a refund of the excess EITC amount.

Tap retirement accounts early

In dire situations, you might be tempted to cash out a retirement plan. If you do, be prepared to pay a 10 percent early withdrawal penalty if you are not yet age 59 ½ and take money out of a traditional individual retirement account or are younger than 55 and take a 401(k) distribution.

The penalty is waived, however, if you use your IRA money to pay for unreimbursed medical expenses that total more than 7.5 percent of your income in 2012 or 10 percent of your income in 2013. Workers who receive unemployment compensation for 12 consecutive weeks can also use money from an IRA, but not a 401(k), to pay for medical insurance.

A hardship withdrawal from a workplace retirement plan is allowed penalty-free if, according to the IRS, the distribution is for "an immediate and heavy financial need." This includes such things as medical expenses, certain educational expenses and payments necessary to prevent eviction from, or foreclosure on, your home.