5 terrible tax surprises

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You’ve always followed the sage advice of the late singer-songwriter Jim Croce: You don’t tug on Superman’s cape, spit into the wind or try to pull a fast one on the IRS.

OK, maybe that last one wasn’t one of Jim’s lyrics, but the sentiment — know the consequences before you act — still applies.

Unfortunately, that’s not always easy to do when it comes to Uncle Sam’s tax collectors.

The tax law is complex and difficult for even experts to negotiate. Just when you think you’ve followed all the rules and researched all the angles, a tax regulation blindsides you.

Surprising tax laws
There are many arcane and infuriating tax laws that cause filers problems. Here are five that many people might run afoul of during tax season.
  1. Unemployment benefits
  2. Alimony payments
  3. Forgiven debt
  4. Prize winnings
  5. Social Security retirement payments

Unemployment benefits

Yes, it’s true. Your unemployment benefits are taxable.

Under tax law, unemployment is considered wage income and the IRS wants a cut of every type of income you collect.

Now that you’re over the shock and anger, what can you do?

If you get laid off, when you apply for unemployment benefits consider having federal income taxes withheld. This process is similar to the payroll withholding you encounter when you collect a paycheck. In this case, the form you fill out is the federal W-4V, Voluntary Withholding Request, or a similar, IRS-acceptable document that the paying agency has created. This way, taxes will be withheld at the rate of 10 percent of each unemployment payment.

However, since unemployment compensation is usually less (and sometimes a lot less) than your former paycheck, most people decide against having taxes withheld. This means you get your full unemployment check to use toward day-to-day expenses. But it also means you’ll owe the IRS when you file your next income tax return.

You can avoid a big lump-sum tax bill on April 15 by paying quarterly estimated taxes on your unemployment income. And for help on managing your finances and taxes after getting a pink slip, check out this Bankrate article.

Alimony received

You survived the divorce. Now you’ve got the IRS to deal with if you’re getting alimony.

Ending a marriage is never a happy event. But at least you got a good settlement and those regular checks from your (insert your own description here) ex-spouse are completely warranted. They also are completely taxable.

Alimony, separate maintenance payments and similar recompense from your spouse or former spouse are taxable to you in the year you receive them. Child support money, however, is not taxable. If your divorce decree calls for both alimony and child support and specifies amounts for each, you only owe the IRS for the alimony payments.

If your divorce attorney was really, really good, those hefty post-marriage payments could produce a larger-than-expected tax bill when you file your return. Since the IRS doesn’t have a mechanism for collecting taxes from alimony checks as you get them, you’ll have to pay all taxes due on the income in a lump sum by April 15.

You can avoid this unwelcome tax surprise by making quarterly estimated tax payments mentioned earlier on your alimony income. Alimony payments made by an ex-spouse also have tax considerations, but in that instance the payer can deduct them. Regardless of whether you’re receiving or paying alimony, you’ll need to focus on maintaining your credit and managing your finances after the divorce decree is issued.

Forgiven debt

Forgive but collect is the IRS motto when it comes to canceled debt.

Did you lose control of your credit cards to the point that you simply were unable to pay the balance? What a relief it was when you discovered you could negotiate with your credit card company to get it to accept just half of what you owed. This amount is known as forgiven, or canceled, debt.

Getting your credit card bill cut from eight grand to $4,000 certainly helped your personal bottom line. But it also could be a boon to the U.S. Treasury. Why? The tax law generally considers the amount you get Visa, MasterCard or any creditor to write off as earned, and therefore taxable, income to you. Expect the accommodating debt-holder to send you a Form 1099 detailing your discharge of indebtedness as miscellaneous income.

You say you didn’t get the official tax statement? Don’t breathe too easy. It’s quite possible that your unexpected cancellation of debt income was reported to the IRS even though the company accountant didn’t fill out your form.

Not every debt settlement, however, has to pad Uncle Sam’s pocket. Under the Mortgage Debt Relief Act that became law in late 2007, for example, some homeowners who are granted forgiveness of mortgage debt won’t have to pay taxes on that amount.

There are some restrictions. The forgiven debt amount is limited to up to $2 million or $1 million for a married person filing a separate return. The tax relief only applies to mortgage debt discharged by a lender in 2007, 2008 or 2009. And the must have been taken out to buy or build a primary residence, not a second or vacation home.

And to help you avoid getting into a situation where you have to throw yourself on the mercy of those you owe, Bankrate has an extensive collection of debt management articles.

Prize winnings

Think you’re pretty lucky because you won $1,000 in a radio contest? Uncle Sam is even luckier. He’s due part of your winnings.

Prize winnings are included in the long list of “other” income that the tax law says is taxable. And it’s not just limited to cash awards. You’ve got to pay taxes on the fair market value of any property you win. So get ready to come up with some cash for Uncle Sam to cover that new Corvette the local Chevrolet dealership presented to you as part of its latest promotional contest.

Be careful when reporting the amount of a noncash prize. In most cases, companies and groups that award prizes, both cash and property, will send you a 1099 form declaring the value of what you won. If your tax return reports substantially less than what the giver claims, your under-reporting could mean a long, hard look from an IRS auditor.

But don’t cheat yourself, either. It’s not inconceivable for a prize presenter to overvalue a gift. If you find yourself in this situation, it is possible to do your tax duty without paying too much. Bankrate’s tax adviser George Saenz has some advice on how to reduce your taxable prize amount.

And don’t forget about gambling proceeds. They’re taxable, too, but at least you get the chance to reduce the tax bite here by subtracting any betting losses from your winnings.

Some Social Security benefits

You spent the last 40 years fattening the U.S. Treasury thanks to those dang Social Security taxes that came out of every paycheck. Now you’re retiring and it’s time to get your tax money back, free and clear, right?

Well, maybe. Maybe not.

You certainly are entitled to the Social Security benefits your payroll taxes went toward. But the IRS also could take a bite out of those federal retirement checks.

Generally, if Social Security benefits are your only income, your benefits are not taxable. From the IRS’s standpoint, Social Security benefits include monthly survivor and disability benefits; supplemental security income payments are not taxable.

But if you collect Social Security plus other income, as much as 85 percent of what Uncle Sam pays you could be subject to tax. To figure out just how much in taxes your Social Security might cost you, you’ll have to do some calculating using the work sheet found in your 1040 or 1040A tax package.

If you discover that you will owe taxes on some of your Social Security benefits, there are two ways to deal with them. You can make estimated tax payments on the government check amounts. Or you can have federal income tax withheld from your benefits by completing Form W-4V, Voluntary Withholding Request, and filing it with the Social Security Administration.

This tax tip has more details on taxation of federal retirement benefits. And for more financial strategies as you count down to retirement, check out Bankrate’s collection of retirement planning stories.