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Guest blogger Sonja Felder is principal of Savutax Consulting Group, specializing in the tax needs of small businesses. Today she is sharing her experiences with the unemployed, part-time workers and consultants.
We are living in a time when the future is uncertain. For those who have been laid off, the length of time it will likely take to get a new job with comparable pay may take longer than expected. Many of us will maintain our financial status quo for as long as possible, digging into savings and collecting unemployment to help keep up our lifestyles.
A good number of us are also living on our 401Ks, pensions and IRAs. Money saved for retirement is now helping people to support their current living situations.
But when tax time comes, many people are in for a surprise. In my more than 20 years assisting people with their taxes, I find that many are not ready for the tax impact of digging into their retirement fund or of receiving unemployment benefits longterm.
Here is what you should know about the tax impact of trying to make ends meet.
Unemployment — Unemployment benefits are taxable both on the federal and state level. In 2009, as part of the stimulus plan, the first $2,400 of unemployment is tax free. But the remaining amount is taxable. This means that after the first $2,400, the rest of your unemployment benefits is taxed at your applicable federal and state tax rate.
The potential impact is that you will receive a decrease in your refund, or it is possible that you might owe money, depending on your tax situation.
While it is too late to plan for 2009, you can hedge your situation in 2010 if you are still receiving unemployment benefits. Most states allow for the option to have taxes withheld from the benefit amount before they send you the check. If you can’t afford to have taxes withheld for the entire time you receive benefits, you can opt for having taxes withheld for a part of the time, say half a year, if you end up receiving unemployment through all the extensions.
401K, Pension or IRA — Many will opt to cash out their retirement instead of rolling the amount to another institution. Here’s what you should know: If you are under age 59 ½ , then the amount of the distribution is added to your taxable income, increasing your tax liability and a 10 percent penalty will also be added. Roth IRAs or distributions contributed to a retirement plan after tax dollars are only subject to the 10 percent penalty.
With Roth IRAs or after-tax dollars contributed to a 401K plan, the amount was already taxed prior to the contribution. As such, the amount withdrawn is not taxed again. However, the distribution will be subject to the 10 percent penalty for early withdrawal. If possible, access this money first, before pre-tax distributions.
If you decided to withdraw retirement money before age 59 ½, institutions withhold a required 20 percent from your distribution. The 20 percent will usually cover a taxpayer’s tax liability. But sometimes, it’s not enough. For example, if you elected not to have state tax withheld from your distribution, it is possible to receive a refund from federal, and owe the state. If possible, have state tax withheld if you live in a state that has personal income tax.
You should also be aware there are some exceptions that might reduce the 10 percent penalty, such as being disabled, medical expenses or qualified education expenses. Persons over the age of 59 ½ are not subject to the 10 percent penalty. However, the distribution might still taxable.
One more thing to look out for is working gigs, or part-time jobs with multiple companies. Taxes are withheld from wages based on a percentage of your income. The smaller the amount, the less is withheld. When working for one employer, this is not a problem because the amount withheld is consistent. However, if you work for multiple employers in the year, the withholding amounts withheld are not consistent and by the time the end of the year comes, the total of the amount earned is taxed based on a percentage, but the withholding amounts withheld from each check combined might not be enough.
I suggest keeping your withholding allowance (from your W-4) a little lower or the same as if you were working fulltime. The temptation is to increase the allowance so that you will have more take home pay, perhaps because the wages are lower than you used to receive. But again, if you are working multiple jobs, this might not be a good tax strategy.
Every tax situation is different, based on whether you are single, married, or whether you have dependents.
If your income falls within a specific range, you may qualify for the Earned Income Credit (EIC). In which case, the credit may offset any potential tax liability mentioned above. For a single person with no dependents, the maximum earned income amount is $13,440. For a married couple with three or more children, the maximum earned income amount is $48,279. Keep in mind, this is an earned income credit. Unemployment benefits do not qualify you for this credit.
Understanding these tax pit falls, should help with planning your finances. Tax time may come only once a year, but it’s something that we have to keep in mind for the entire year, especially if we’re not working a regular job.