Look Before You Draw
Unemployed? Don't make these four common — and taxing — mistakes
And these missteps may get more common in the year ahead. Some expect the nationwide unemployment rate to hit 9.5% by the end of 2010. That's almost one person in 10, or at least two or three people on your block. IBM just cut 4,200 people, Caterpillar slashed 20,000 jobs, Home Depot is laying off 7,000 people, and so on.
Unemployment insurance income is rarely adequate to cover basic living expenses and fixed costs, and unemployed individuals generally tap into assets with the highest tax consequences, even though other options are available. Often, by the time folks go to a tax professional, the damage is done, Martin said.
Here are some of the most common tax errors — and ways to avoid them.
1. Not Withholding Income Taxes on Unemployment Benefits
Plenty of people opt to collect unemployment income without having federal withholding deducted. Yes, it's tempting to receive the full check. But how are you going to pay the taxes on the unemployment income in April? You won't have the money.
SOLUTION: Have the withholding taken out, or have the discipline to set aside at least 15% of the money in a savings account you don't touch.
2. 401(k) withdrawals
It's almost instinctive: The first thing you do when you're out of work and need money is tap into your 401(k) plan. Why is this a bad idea? Three reasons:
One, often people draw the money thinking it qualifies for exceptions to the penalties, but the exceptions often only relate to draws from IRAs, not 401(k)s.
Two, it's very expensive money, costing as much as 50% of the amount drawn. There's the penalty of 10% from the IRS. Then there's the tax: 25% plus state tax. In addition, the draw increases your tax bracket and may increase your income so you lose other deductions or credits. And, you permanently deplete your retirement savings.
Three, and worst of all, when it comes time to pay the tax, you won't have the money. You will start a pattern of tax debt overshadowing your life and finances for the next several years.
SOLUTION: There are three options.
One, if there is a lot of money in the account, you can roll the money into an IRA and set up withdrawals allowing you to take substantially equal periodic payments (monthly or annually) over your life expectancy. You will pay taxes on the money — consider this a replacement for your wages - but you will avoid IRS early withdrawal penalties.
Two, start a business. With so many people unemployed right along with you, odds are that you will not get a job quickly, certainly not one earning what you used to earn. So you may well start a business.
And, three, work part time. In Pennsylvania you can work part time, earning up to 40% of your unemployment benefits and still keep all of the unemployment check.
3. IRA withdrawals
That's usually the next step for unemployed folks. Don't just take the money as you need it, without any planning. Think through your financial needs and withdraw the money properly. There are several ways for unemployed folks to pull money from IRAs without facing those harsh early withdrawal penalties. Taxes will still apply.
SOLUTION: As part of your planning, assess your health. If you have been just hanging on thinking you had no choice but to work, it's time to start thinking about getting your health evaluated to see if you should still be working. Some special benefits that might result? You could switch your unemployment benefits to disability benefits, which are not taxable. Or, you might qualify for Social Security disability payments, which would allow you to draw Social Security funds early.
Another possible plan: Withdraw money to cover your health insurance premiums while you're unemployed.
Or, this may be a good opportunity to go back to school and get retrained for another career or profession. Funds paid directly to a qualified educational institution will avoid the penalty. In addition, you may qualify for the lifetime learning credit or the education expense deductions.
Another possible plan: Buying a home. You may draw up to $10,000 for the down payment of a first home (if neither you nor your spouse owned a home within the last two years). With the real-estate market so depressed, now may be a good time to buy a new home. And, not only can you get the down payment money penalty-free, if you close escrow before June 30, 2009 you may qualify for the first-time homebuyers credit of up to $7,500. That may be enough to help you get through the year.
If you can't find any other means of gainful employment, you could live in the house for two years, fix it up and sell it or rent it out - and collect the stream of income.
4. Dumping your home
Another pitfall is walking away from a home that is worth substantially less than the loan balance. You may find yourself facing taxes on phantom income — cancellation of debt. The rules are complicated, depending on the nature of the loan contract, and your state of residence. There may be ways around the extra taxes, using IRS' insolvency rules or by filing bankruptcy before disposing of the home.
And these missteps may get more common in the year ahead. Some expect the nationwide unemployment rate to hit 9.5% by the end of 2010. That's almost one person in 10, or at least two or three people on your block. IBM just cut 4,200 people, Caterpillar slashed 20,000 jobs, Home Depot is laying off 7,000 people, and so on.
Unemployment insurance income is rarely adequate to cover basic living expenses and fixed costs, and unemployed individuals generally tap into assets with the highest tax consequences, even though other options are available. Often, by the time folks go to a tax professional, the damage is done, Martin said.
Here are some of the most common tax errors — and ways to avoid them.
1. Not Withholding Income Taxes on Unemployment Benefits
Plenty of people opt to collect unemployment income without having federal withholding deducted. Yes, it's tempting to receive the full check. But how are you going to pay the taxes on the unemployment income in April? You won't have the money.
SOLUTION: Have the withholding taken out, or have the discipline to set aside at least 15% of the money in a savings account you don't touch.
2. 401(k) withdrawals
It's almost instinctive: The first thing you do when you're out of work and need money is tap into your 401(k) plan. Why is this a bad idea? Three reasons:
One, often people draw the money thinking it qualifies for exceptions to the penalties, but the exceptions often only relate to draws from IRAs, not 401(k)s.
Two, it's very expensive money, costing as much as 50% of the amount drawn. There's the penalty of 10% from the IRS. Then there's the tax: 25% plus state tax. In addition, the draw increases your tax bracket and may increase your income so you lose other deductions or credits. And, you permanently deplete your retirement savings.
Three, and worst of all, when it comes time to pay the tax, you won't have the money. You will start a pattern of tax debt overshadowing your life and finances for the next several years.
SOLUTION: There are three options.
One, if there is a lot of money in the account, you can roll the money into an IRA and set up withdrawals allowing you to take substantially equal periodic payments (monthly or annually) over your life expectancy. You will pay taxes on the money — consider this a replacement for your wages - but you will avoid IRS early withdrawal penalties.
Two, start a business. With so many people unemployed right along with you, odds are that you will not get a job quickly, certainly not one earning what you used to earn. So you may well start a business.
And, three, work part time. In Pennsylvania you can work part time, earning up to 40% of your unemployment benefits and still keep all of the unemployment check.
3. IRA withdrawals
That's usually the next step for unemployed folks. Don't just take the money as you need it, without any planning. Think through your financial needs and withdraw the money properly. There are several ways for unemployed folks to pull money from IRAs without facing those harsh early withdrawal penalties. Taxes will still apply.
SOLUTION: As part of your planning, assess your health. If you have been just hanging on thinking you had no choice but to work, it's time to start thinking about getting your health evaluated to see if you should still be working. Some special benefits that might result? You could switch your unemployment benefits to disability benefits, which are not taxable. Or, you might qualify for Social Security disability payments, which would allow you to draw Social Security funds early.
Another possible plan: Withdraw money to cover your health insurance premiums while you're unemployed.
Or, this may be a good opportunity to go back to school and get retrained for another career or profession. Funds paid directly to a qualified educational institution will avoid the penalty. In addition, you may qualify for the lifetime learning credit or the education expense deductions.
Another possible plan: Buying a home. You may draw up to $10,000 for the down payment of a first home (if neither you nor your spouse owned a home within the last two years). With the real-estate market so depressed, now may be a good time to buy a new home. And, not only can you get the down payment money penalty-free, if you close escrow before June 30, 2009 you may qualify for the first-time homebuyers credit of up to $7,500. That may be enough to help you get through the year.
If you can't find any other means of gainful employment, you could live in the house for two years, fix it up and sell it or rent it out - and collect the stream of income.
4. Dumping your home
Another pitfall is walking away from a home that is worth substantially less than the loan balance. You may find yourself facing taxes on phantom income — cancellation of debt. The rules are complicated, depending on the nature of the loan contract, and your state of residence. There may be ways around the extra taxes, using IRS' insolvency rules or by filing bankruptcy before disposing of the home.
Comments