The "What-Ifs" of a Financial Recession

A downturn in your financial situation has an immediate impact on you and your family. Not to be discounted is the potential tax impact that difficult financial times can bring about.

In some cases, your tax could increase if you are forced into certain monetary decisions. On the other hand, if your income decreased, you may be eligible for certain tax credits and benefits.

Here are some "what if" scenarios and the possible tax effects:

What if I lose my job?

If you lose your job, you may be presented with a severance package. You also may qualify to start drawing unemployment. Both are fully taxable. Most states allow an election to have tax withheld from unemployment. You may not want to, but having tax withheld can avoid you finding you owe on your tax return.

If you take cash out of a 401 plan and do not roll it over within 60 days into a qualified IRA, you will be taxed on the distribution.

If you qualify for public assistance, such as welfare or food stamps, these programs are not taxable.

Remember too that you can deduct expenses related to a job search, such as travel and resume expenses and outplacement agency fees. You can also deduct moving expenses if you relocated to start a new job.

What if I was forced to take a reduction in pay?

This may mean that you fell out of a higher tax bracket and now will pay less in tax each year. If so, consider changing and submitting a new W-4 to your employer so that you have more money in your take-home pay.

Additionally, you may now be eligible to take the Earned Income Tax Credit, a government credit available to lower income families and individuals.

What if I withdraw money from my IRA?

You can't borrow from your IRA, but you can take early withdrawals. In addition to the tax you must pay on any distribution, if you are under the age of 59 1/2, you will pay a 10 percent early withdrawal penalty.

In some cases, the early penalty can be waived for hardship provisions. See IRS Publication 590 for more information.

What if I loss money that was invested in my 401 Plan?

According to the IRS, you cannot claim a capital gains loss on retirement accounts that already are receiving favorable tax treatment. The only time you would have a deductable loss is when you receive a distribution that had previously been taxed.

What if my home is foreclosed on?

Under the Mortgage Forgiveness Debt Relief Act of 2007, taxpayers generally can exclude from their income the discharge of debt on their principal residence only. This does not apply to secondary homes or vacation homes or property. If you short-sell your home for a loss, you cannot take a capital gains loss since your home is personal use property.

What if a lender forgives an amount I owe?

Forgive is a relative term here. If a lender remains unpaid, especially an unsecured creditor like a credit card company, they may be forced to "forgive" or write-off the amount you owe them. Consumer lenders have no recourse to seize collateral, like your home mortgage holder or car financier, so the debt may be absolved, with a negative report going on your credit.

When a debt is cancelled, a 1099-C document will be sent to you. In most cases, you are then responsible for paying the tax on the amount of the canceled debt.

What if I file for bankruptcy protection?

By law, if a taxpayer files for bankruptcy, the IRS must cease all efforts to collect delinquent tax debt. IRS tax balances can be included in a bankruptcy filing, but may or may not be discharged. This depends on the age and type of tax debt you owe, as well as the Chapter under which you have filed bankruptcy.

See the links to the articles below for more information.

More from this Contributor:

How does a bankruptcy filing affect IRS tax debt?

Can't pay your tax debt? You may qualify for IRS non-collectible status

What should you do if you owe the IRS?