By Eva Rosenberg, MarketWatch
LOS ANGELES (MarketWatch) -- Losing a job is bad enough. Unfortunately, many people only compound the problem with personal-finance moves that lead to big tax bills later.
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.
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Perhaps you'll stay lucky and keep your job this year, or your business will remain solvent, but if not, think before drawing taxable funds.
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, said Mike Martin, an enrolled agent and president of Mike Martin & Associates in Independence, Mo.
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. Avoiding withholding
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.
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.
If you get sick while you're on unemployment, remember to switch your benefits to disability benefits. Those checks are usually higher -- and the income is not taxable.
If your prospects for getting a job look really bleak for the year ahead, consider this interesting suggestion from Doug Thorburn, a Northridge, Calif.-based enrolled agent: See if the tax benefits of being claimed as someone else's dependent are substantial. If they are, consider halting your unemployment benefits before your total income for the year reaches $3,500. This definitely takes some planning.
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 and whatever your state penalty is (not all states have penalties). 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 two to 10 years.
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