March 22, 2009 -- Nearly everyone is feeling some financial pain these days, whether from job loss, stock market losses or the real estate collapse. That means many taxpayers are facing unfamiliar issues, deductions and traps on their 2008 tax returns and in their tax planning.
The questions are legion, and the answers often aren't simple, let alone what a sensible person might assume. When can you deduct losses, job hunting expenses or moving costs? If you're strapped for cash, can you tap into retirement accounts without penalties? If you want to help others, what are the tax angles?
Frequent changes to the tax law further complicate matters. Example: You might have heard the stimulus passed in February exempts $2,400 of unemployment benefits from inclusion in your taxable income. That, however, is for 2009. If you're preparing 2008 returns, all your unemployment checks are subject to federal income tax (although not Social Security and Medicare taxes). Still, some states, including California and Michigan, don't tax unemployment benefits -- so check yours. Note that any severance payments you receive are subject to income, Social Security and Medicare taxes.
One confusing area: losses. As a general rule, the tax code isn't very generous when it comes to writing off non-business losses, although Congress and the IRS have made a few notable taxpayer-friendly changes recently. (One is for losses suffered in a presidentially declared disaster area; for details, see IRS publication 547, "Casualties, Disasters and Thefts.")
Just last week, the IRS, under pressure from Congress, issued new rules that will allow victims of Bernard Madoff's $65 billion Ponzi fraud and similar schemes to claim investment-theft losses that could generate billions of refunds of taxes they paid over the last five years.
Many more taxpayers, however, have been hit by plunging stocks than have come into contact with floods, wildfires or con men, and there's little good news for them.
Sure, losses you've taken on the sale of stocks and mutual funds in taxable accounts can be used to offset any capital gains. But only $3,000 of your net capital losses each year can be deducted against ordinary income -- meaning income from your salary. The rest are carried forward to offset whatever gains you may have in the future, plus $3,000 of ordinary income a year. For more on making the most from your stock losses, go here.
What about retirement accounts? That's what clients have been asking William Stevenson, president of National Tax Consultants in Merrick, N.Y. "People never really thought about losses in retirement plans before. They're still in shock,'' he says. The answer: No matter how steep the losses in your pretax 401(k) or pretax IRA, you can't deduct them, since the money in those accounts was never taxed to begin with. On the other hand, losses in Roth IRAs and 529 college savings accounts (both funded with already-taxed money) may be deductible and worth taking in certain cases.
If you liquidate all of the Roth IRAs you own, or all of the 529 accounts you hold for the benefit of a single child, and what you realize is less than you put in, you can claim a loss, but not on Schedule D, where you report capital losses. Instead, the loss is claimed on Schedule A as a miscellaneous itemized deduction. Such deductions can only be taken to the extent they exceed 2 percent of your adjusted gross income and aren't allowed at all in the alternative minimum tax calculation. Still, if you put a big slug of money into a 529 before the market tanked, the deduction might be useful. Plus, you can put money back into a 529 later--just wait more than 60 days so the IRS won't treat this as a rollover, says Jim Van Grevenhof, a senior tax analyst at Thomson Reuters.
Losses on the sale of your primary residence? Not deductible. Congress has given some relief, however, to those who renegotiate their mortgages or lose their homes to foreclosure. In such cases, the lender is likely to forgive some debt, which traditionally counts as income to a taxpayer--unless, that is, he's in bankruptcy or insolvent. If you've received a 1099-C from a lender reporting cancellation of debt income, check out Form 982; you may be able to take advantage of a provision passed in 2007 excluding certain forgiven mortgage debt from income.
Another tricky issue: getting money out of pretax retirement accounts without incurring the normal 10 percent early withdrawal penalty, for reclaiming money before age 59 1/2. The penalty is on top of any regular tax you might owe.
If you're strapped for cash, or fear you will be soon, you can still take back any contributions you made to an IRA for 2008, so long as you do this before filing your return and report any earnings on that contribution (yeah, sure) as income. In addition, you can withdraw any year's contributions to a Roth IRA without penalty, since they were all made after tax.
If you lose your job, a few special rules may help: If you're 55, you can access money in a pension plan such as a 401(k) without the 10 percent penalty. (You will still owe regular income taxes on the payouts.) No similar exemption exists for IRAs, but there are narrower ones. You can take money from an IRA, without penalty, to pay bills for higher education, for certain medical expenses and if you've been collecting unemployment for 12 weeks, to pay health insurance premiums. For details, see IRS publication 590, "Individual Retirement Arrangements (IRAs)".
Meanwhile, if you can't pay all you owe come April 15, file your return or a request for an extension anyway. If you don't file, there's a 5 percent per month penalty on the balance due, whereas if you file (or request an extension) and can't pay, the penalty is just 0.5 percent per month. (Both penalties top out at 25 percent of the amount due and are in addition to interest.)