The IRS has a handy guide called "The What Ifs of an Economic Downturn" (search www.irs.gov) that reviews the tax impacts of different scenarios such as job loss, debt forgiveness or tapping a retirement fund.
Here's a roundup of common economic challenges you may be facing and their possible tax implications:
You lost your job. Remember that unemployment benefits, severance pay and payout of accumulated vacation or sick leave are all considered taxable income, so if you didn't have taxes withheld from these payments, be prepared for a potentially nasty tax bill.
If you withdrew money from your regular IRA or 401(k) account to cover expenses, you'll owe income tax on the amount, plus an additional 10% penalty unless you're over age 59-1/2 or meet special circumstances. Also, outstanding 401(k) loans must be repaid (usually within 60 to 90 days of termination) or they'll be counted taxable income, plus be subject to the same 10% penalty.
The good news is that many public assistance benefits such as welfare, food stamps and disaster relief payments don't count toward taxable income. Read the IRS's "Tax Impact of Job Loss" for details (www.irs.gov/pub/irs-pdf/p4128.pdf).
Lowered income. If you took a big pay cut or lost your job in 2011, it might lower your adjusted gross income enough to qualify for the Earned Income Tax Credit. EITC is a "refundable" tax credit, which means that if you owe less in income tax than your eligible credit, you'll not only pay no tax, but actually get a refund for the difference. To learn more, search EITC at www.irs.gov.
Forgiven debt. Many people don't realize that when you borrow money from a bank or other commercial lender and the lender "forgives" the debt, you generally must count the forgiven amount as taxable income.
There are several exceptions to the rule, however: For example, the Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude up to $2 million in forgiven mortgage debt ($1 million if married filing separately) on their principal residence if it came through mortgage restructuring, foreclosure or a short sale. The mortgage exclusion is set to expire at the end of 2012 unless Congress intervenes.
Other exceptions include: debts discharged through bankruptcy; or, if you are insolvent when the debt is cancelled, some or all of it may not be taxable. (Insolvency means your total debts are greater than the fair market value of your total assets.) For more information, search for Mortgage Debt Forgiveness at www.irs.gov.
Taxes are the last thing you want to worry about when facing financial hardships. Just be sure you're prepared for the possible tax implications if your income or debt situation has changed in the past year.
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