Many taxpayers continue to be affected by the U.S. recession, especially if they were strapped for funds in 2010 and needed to borrow from their 401(k).

Those taxpayers, who may have borrowed from their 401(k) plan, life insurance policy, or credit card; took a home-equity loan; received a 401(k) plan or IRA distribution; cashed out a life insurance policy; collected severance pay or unemployment compensation; incurred job-search expenses; or even sold securities, should consider the following when they file their 2010 tax returns:

What income is reportable?

•  Unemployment compensation/severance pay/outplacement. Unlike in 2009, when there was an exclusion for up to $2,400 of unemployment compensation, these benefits are taxable income for federal tax purposes if received in 2010. (However, they may be exempt from state tax.) Severance pay is taxable income subject to federal income tax withholding. If you received job placement assistance from your ex-employer, its value is tax-free, unless you had the option of taking either the outplacement help or its value in cash. So, if you had a choice and the value was, for example, $1,000, it is reportable income whether you took the assistance or the cash.

•  401(k) or IRA distribution. If you took a distribution from your former (or current) employer’s 401(k) plan or your IRA in 2010, and didn’t roll the proceeds over into an IRA within 60 days, you owe ordinary income tax on the distribution, plus a 10 percent penalty (unless you are over age 59-1/2, or qualify for another penalty exception).

•  401(k) loan. If you took a loan from your current or former employer’s 401(k) plan in 2010, it is ordinarily a taxable distribution, but if the plan provides for loans, the funds could be tax-free. To be nontaxable, the funds must be repaid evenly over no more than five years (longer if the loan was to purchase a residence) and, if more than $10,000, cannot exceed the lesser of $50,000 or 50 percent of the value of your nonforfeitable accrued benefit (generally, your vested benefit). The interest you pay on the loan is ordinarily nondeductible.

Life insurance policy cash-out/loan. If you cashed out (surrendered) an insurance policy in 2010 and you neither received any distributions under the contract nor borrowed against the contract's cash surrender value before surrender, you recognize ordinary income to the extent the amount you received exceeds the aggregate premiums you paid. So, if you paid $4,500 in premiums, never received distributions or borrowed before surrender, and received $6,000 on surrender, you recognize $1,500 ($6,000 less $4,500) in income.

“If you borrowed against the policy, the rules on what is taxable are even trickier; you probably need a tax professional’s help,” said Lesli S. Laffie, senior tax analyst for the Tax & Accounting business of Thomson Reuters. “And, generally, no deduction is allowed for interest paid on the life insurance loan.”

Are any deductions available?

•  Job-search costs. You can deduct job-search expenses to the extent your total miscellaneous itemized deductions on Schedule A (including the job search expenses) exceed two percent of your adjusted gross income (AGI) for 2010. This includes the costs of an unsuccessful search or if you decide not to accept a new position offered. You must have been looking for employment in 2010 in the same occupation or trade or business in which you were engaged as an employee (e.g., an engineer pursuing engineering jobs, but not a florist seeking work as a hairstylist.)

Some of the more common deductible job-search expenses are: the cost of resume preparation and distribution; job counseling and referral fees; employment agency fees; postage and telephone charges related to seeking new employment; local and out-of-town travel for interviews (not reimbursed by the prospective employer); and subscriptions to daily newspapers with classified ads, Internet job-search sites, and professional journals and newsletters.

Credit card/home-equity loan. Generally, if an individual borrows from a credit card, the interest incurred is “personal interest” and is nondeductible (some exceptions apply). But a taxpayer who borrows via a home-equity loan (a debt secured by a taxpayer’s qualified residence) normally can deduct interest paid (even if the funds are not used to improve the residence), if various limits and rules are met. 

Did you sell securities?

Generally, an individual’s sale of stock or securities generates capital gain or loss. The tax treatment of capital gains and losses depends on whether they are long-term or short-term. If the item was held for one year or less, short-term gain or loss rules apply. If the item was held for more than one year, long-term gain or loss rules apply. The maximum tax rate on long-term capital gains for individuals is 15 percent; short-term gains are taxable at the same rates as ordinary income. Netting, wash-sale, and other rules apply. Up to $3,000 of excess net capital losses can be offset against other income; unused losses can be carried over indefinitely.

More recession-related woes: your taxes.

“Actions taken by cash-strapped taxpayers can have unintended tax consequences,” says Laffie, “and the rules can be complicated. To get the most favorable tax results, it may be worth seeking out an experienced tax professional.”

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