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Don't forget about unemployment benefits at tax time

There's finally some good news to report on the job front. In January, the national unemployment rate dropped to 9.7%, the lowest since August 2009. And the news got even better last week when the Labor Department reported that there were 440,000 initial jobless claims filed in the week ended February 6, down almost 10% from the previous week.

It may be a sign that the economy is on its way to recovery -- but more work is still needed in Washington. It will clearly take some time to climb out of a hole that saw 150,000 jobs lost last December alone.

Last year, the federal government took measures to offer some relief to the more than 4.5 million people still looking for work. The American Recovery and Reinvestment Act (ARRA) included a provision that exempts the first $2,400 in unemployment benefits from federal income tax. In prior years, all unemployment benefits were taxable for income tax purposes at the federal level.

Any unemployment benefits over the exempt amount are still taxable, in addition to other sources of income, such as interest and dividends.

Here's where it can get tricky: Unlike your "normal" paycheck, many unemployment checks don't reflect an appropriate amount of withholding. This is because many states allow you to opt out of federal income tax withholding from your benefits during the year. Less withholding during the year may mean more to pay out at tax time.

If you elect not to have federal income tax withheld from your benefits check, you should make estimated payments during the year in order to ease your tax bite and avoid a possible penalty. To do this, you'll need to complete a form 1040-ES. The form 1040-ES will provide you with a series of payment coupons you can use to make payments during 2010. Most tax preparation software packages and tax professionals can figure these amounts for you during the year when you file your taxes for the 2009 tax year.

The exemption for unemployment compensation benefits applies whether you were unemployed for all or part of the year. Additionally, the regular income limits for filing a tax return still apply.

Don't forget to offset your taxes, if you qualify, with the applicable deductions (for both those who itemize and those who don't) and credits. Some deductions, like job search expenses, may be particularly timely.

If all of this seems a bit overwhelming, remember that free tax help is available.

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