August 15, 2014

If you lose your job unexpectedly, your first reaction may be to panic. Your second reaction may be to despair about whether you will ever work again. What you may not consider are the implications for federal and state income taxes. But you will have to deal with your taxes sooner or later. Fortunately, the IRS provides tax breaks that may ease the blow of losing your job, and make the task of seeking a new job easier.

1. Don’t Forget to File Your Return

This may seem painfully obvious, but in your efforts to deal with reduced (or no) income, resumes and job interviews, tasks like filing your income tax return can be shoved to the side. The silver lining is that depending on how long you’ve been unemployed, you may qualify for a sizeable tax refund, which would provide much needed cash. If you lose your job right before the filing deadline, and you really just can’t handle filing a return, file a request for an automatic extension to give yourself an extra six months. But don’t forget to pay at least an estimated amount of taxes that you owe to avoid underpayment penalties.

2. Utilize Free Income Tax Filing Services

If you never took advantage of free tax filing services before, now is the time to check out this benefit. The IRS allows taxpayers with adjusted gross incomes under a certain amount ($58,000 for 2013 tax returns) to file their federal returns for no charge through the Free File program. Many states also allow taxpayers to file their income taxes for free. Depending on your circumstances, you may also qualify for face-to-face assistance in filing your income tax returns from nonprofit agencies in your area.

3. Keep Track of Job Search Expenses

If you always just take the standard deduction, you may wish to reconsider that position once you become unemployed. That’s because job search expenses for a position in your present line of work are tax deductible, but only if you itemize your deductions. Job search expenses must exceed 2 percent of your adjusted gross income to be deductible, but if you are receiving unemployment or no income at all, this hurdle is relatively easy to overcome. Expenses such as printing and mailing resumes, travel expenses for job interviews, employment agency fees and career counseling add up quickly.

4. Medical Expenses May be Tax Deductible

Clearing the hurdle of 7.5 percent of adjusted gross income necessary to deduct medical expenses is ordinarily a tall order, barring major surgery or catastrophic illness. But if your income is reduced due to job loss, clearing that hurdle may be easier. Save receipts for doctor visits, prescriptions and over-the-counter medications just in case.

5. Take the Health Insurance Tax Credit if You Qualify

If you lost your job as a result of a foreign trade agreement, you may be able to claim the Health Insurance Tax Credit. You must be receiving Trade Adjustment Assistance benefits to qualify. The HITC covers 80 percent of your health insurance premiums, which can free up a significant amount of cash for other areas of your budget.

6. Consider Your Retirement Plan

If you have an employer-sponsored 401(K), you will need to roll those funds into a traditional IRA or other qualified retirement fund to avoid paying taxes on the money. If you already have a traditional IRA, it may make sense to convert the account to a Roth IRA while your income is lower. You will have to pay income taxes on the funds that you convert, but you may still come out ahead financially in the long term. Consult with Optima Tax Relief to determine the best strategy for you.

7. Take Advantage of Tax Breaks for Low and Moderate Income Earners

Since you lost your job, your income has likely decreased dramatically, while many of your expenses have remained the same. Tax credits like the Earned Income Tax Credit (EITC), the Child Tax Credit, Child and Dependent Care Credit and Savers Credit allow low and moderate income taxpayers to reduce the amount of income that they must declare on their federal income tax returns and in some cases, such as with the EITC, receive a tax refund, even if they don’t actually owe federal income taxes.

8. Don’t Get Blindsided by Taxes on Severance Pay or Unemployment Insurance

It is a cruel irony that unemployment insurance and severance pay are considered taxable income. As painful as it may be, set aside funds from each unemployment check or your severance check to cover your estimated federal income tax liability if at all possible. The IRS receives copies of Form 1099 which reports unemployment income and Form W-2 which reports income – including severance pay – from your former job. Underreporting this income or failing to pay the taxes you owe could land you in serious trouble. The risks simply aren’t worth it.

9. Get to Know Schedule C

While your ultimate goal may be to find another full-time or part-time job, you may take temporary jobs or self employment to fill gaps in your income during your search. Income and expenses from self employment are calculated on Schedule C, which is filed along with your federal income tax return. Deductions and credits differ significantly for income from self employed workers and small business owners than for wage earners.

Depending on how long you remain unemployed, you may be able to claim tax breaks through Schedule C that would be difficult or impossible to claim as a wage earner itemizing your deductions on Schedule A. In particular, self employed workers can claim tax breaks on health insurance premium payments without itemizing deductions. Who knows, you may decide to ditch the job search in favor of full-time self employment.

10. Withdraw from Your Retirement Fund Only as a Last Resort

When the balance in your bank account shrivels and your bills begin to pile up, funds that you have set aside for your kids’ education or for your retirement begin to look like a lifeline. If you are really hard up for money and you must choose between Junior’s education fund and your traditional IRA as a source of much-needed cash, deplete Junior’s college fund first. This is not to punish Junior, but because resources such as grants, scholarships, loans and part-time work are available to assist college students with financial need. If all else fails, Junior can attend a community college for a year or two before transferring to a four-year institution.

On the other hand, draining your retirement fund deprives you of funds that you may or may not be able to replenish. Even if you can replace the funds you withdraw, it is unlikely that you will ever be able to make up for the earnings that those funds would have generated had they remained in your account. Worse, you may have to pay a stiff tax penalty for early withdrawal from your traditional IRA. That said, the IRS allows unemployed taxpayers or their heirs to make hardship withdrawals from traditional IRAs before age 59 ½ without paying a tax penalty under strictly defined circumstances.

The rules for making early withdrawals from a Roth IRA are less strict than for a traditional IRA. Nonetheless it’s still a bad idea to drain your Roth IRA before you intend to retire unless it is absolutely necessary. But if you have both a traditional IRA and a Roth IRA, it may be less financially painful to draw from the Roth IRA. Consult with a tax professional to obtain expert advice about your particular circumstances.

Don’t Give Up

Losing your job and going through the grind of seeking work can wear on even the most determined job seeker. While it’s tempting to give up, you should do whatever you can to continue your search. Taking advantage of tax breaks designed to assist job seekers and other taxpayers with moderate or reduced incomes may help you provide your family’s basic financial necessities until you are back on the job.