Did you know that unemployment compensation is taxable for federal income tax purposes and must be reported as income? Your state’s unemployment agency will report the amount of benefits you received during the year on Form 1099-G. A copy of this form will also be sent to the IRS. You must report these benefits on your tax return.
You can choose to have federal income tax withheld from your unemployment compensation so you don’t have a large tax bill when it’s time to file. However, the amount withheld will be a flat 10 percent, and this may not accurately reflect your actual tax liability. You can file form W-4V (Voluntary Withholding Request) with your state unemployment benefits office to have taxes withheld from your benefits. If you receive benefits for more than three months, you may also be required to file quarterly estimated tax payments to the IRS. Consult with your tax advisor for guidance.
States usually exempt unemployment benefits from state tax liability, but you should check with your tax advisor to be sure.
What about your retirement account at your old job? You also need to handle this issue correctly to avoid tax liability. You may be asked if you want to take your 401(k) with you. Most financial advisors do recommend taking your 401(k), 402(b), or 457(b) and rolling the account over to an individual IRA.
However, make sure you do what’s called a “direct transfer rollover” — transferring the balance in its entirety — from your previous company directly to an IRA account. You can contact a mutual fund company or brokerage firm to arrange the transfer. They will provide a rollover application form. Do not have a check sent to you. If you do, your previous employer will be required to withhold 20 percent of the total amount as federal income tax withholding. However, you must deposit 100 percent of the account balance into an IRA account within 60 days, otherwise you will be charged not only a 10 percent tax penalty for a premature distribution, but also your tax rate on the missing money, with certain limited exceptions.
If you’re in a 25 percent tax bracket, that means you could be penalized 35 percent on the amount missing from the transfer. If you do have the money on hand to contribute the full 100 percent to your IRA (the 80 percent you received as a check, plus 20 percent of your own money), then you’ll have to apply for the 20 percent withholding refund when you file your taxes. Depending on your financial situation, that may be a burden you don’t want to incur, especially if you’re unemployed.
If you choose to cash out your retirement account and take the money as a distribution, you’ll pay income tax on the entire amount of the distribution and you’ll incur a 10 percent early withdrawal penalty if you are not 59-1/2 years old.
If your previous employer offered a pension, you may wish to roll over your pension into an IRA, if that’s allowed by the pension administrator. Pensions are insured by the Pension Benefit Guaranty Corporation (PBGC), but only up to $54,000 and only if you retire at 65.
If you are worried about the financial stability of your previous company and the pension administrator allows you to take a lump sum distribution and roll it into an IRA, you should consider that. Also, remember that in some cases, a pension dies when you do (for example, if you did not choose survivor’s benefits). Or, if you did choose survivor’s benefits but your surviving spouse dies before you do (and you’re already receiving benefits), the pension will end when you die. If you roll your pension into an IRA, however, your account will survive you and can be inherited or donated.
Severance pay may also be taxable. In addition, you may also owe taxes on any accrued vacation, overtime, and/or sick pay that you received when you left the company. If you were participating in a profit-sharing plan, you may have to pay taxes on the money you receive, unless you are eligible to roll these funds over into a traditional IRA account. With a traditional profit-sharing plan, if you’re younger than age 55, you will likely also face a 10 percent penalty on withdrawing your money (although there are some exceptions). You can shield your profit-sharing money from current taxes by rolling it into a traditional IRA. But again, make sure you’re conducting a direct transfer rollover.
If you work as a freelancer or take on work as an independent contractor while you are unemployed, that income must also be reported to the IRS. You report this income on Schedule C (Profit or Loss From Business), if you’re an independent contractor or sole proprietor. If you receive at least $600 in payments from a business, they are required to furnish you with a 1099-MISC form (and will file a copy with the IRS). However, you’re required to report income you receive as cash too.
Also, track your expenses related to your freelance work. You can deduct expenses that are considered “ordinary and necessary” for conducting your business. This can include a portion of your rent or mortgage, utilities, and insurance (if working from home), as well as things like office supplies, equipment, and business-related mileage.
If you’re doing odd jobs or earning money from a hobby, you also need to report this as “other income” to the IRS. And, depending on how much you earn from freelancing or odd jobs, you may also have to make quarterly estimated tax contributions. Check with your tax advisor to be sure.
Note: This information is not intended to provide financial, legal, or tax advice. Consult with a tax accountant for specific guidance.