Fallen On Hard Times? Five Ways The Tax Law Might Help

Economists say the recession is long over but millions of people are hurting and unemployment remains stubbornly high. If you have recently fallen on hard times, the Internal Revenue Service (IRS) says it may be able to help you navigate your changed tax situation and, in some cases, offer some assistance.

There can be a tax impact to events such as job loss, debt forgiveness or tapping a retirement fund. If your income decreased, you may be newly eligible for certain tax credits, such as the Earned Income Tax Credit.

Most importantly, if you believe you may have trouble paying your tax bill you should contact the IRS immediately.

"There are steps we can take to help ease the burden," the agency says on its website. "You also should file a tax return even if you are unable to pay so you can avoid additional penalties."

Here are five economic setbacks and their tax implications:

1. Losing a job

The loss of a job may create new tax issues. Unfortunately, severance pay and unemployment compensation are taxable. Payments for any accumulated vacation or sick time also are taxable. You should ensure that enough taxes are withheld from these payments or make estimated tax payments to avoid a big bill at tax time. Fortunately, public assistance and food stamps are not taxable.

2. Losing your home to foreclosure

Under the Mortgage Forgiveness Debt Relief Act of 2007, taxpayers generally can exclude income from the discharge of debt on their principal residence or mortgage restructuring. This exception does not apply to second homes or vacation homes. In some cases, you may be able to file an amended tax return for previous tax years.

3. Withdrawing money from a retirement account

Because of dire economic circumstances, some consumers have eaten through their savings and have now been forced to tap their retirement accounts. That, of course, has tax implications. Generally, early withdrawal from an Individual Retirement Account prior to age 59½ is subject to being included in gross income plus a 10 percent additional tax penalty. But the IRS will waive the 10 percent penalty in some circumstances, such as using IRA funds to pay your medical insurance premium after a job loss.

4. Filing for bankruptcy

Debts discharged through bankruptcy are not considered taxable income, the IRS says. If you are an individual debtor who files for bankruptcy under chapter 7 or 11 of the Bankruptcy Code, a separate “estate” is created consisting of property that belonged to you before the filing date. This bankruptcy estate is a new taxable entity, completely separate from you as an individual taxpayer. However, some tax debts are not dischargeable in a bankruptcy action. You will definitely need legal advice in cases like this.

5. Can't pay your tax bill

Don’t panic, the IRS says. If you cannot pay the full amount of taxes you owe, you should still file your return by the deadline and pay as much as you can to avoid penalties and interest. You also should contact the IRS to discuss your payment options at 1-800-829-1040. The agency says it may be able to provide some relief such as a short-term extension to pay, an installment agreement or an offer in compromise. In some cases, the agency may be able to waive penalties. However, the agency is unable to waive interest charges which accrue on unpaid tax bills.