Don't be surprised at tax time; prepare for unemployment taxes. February 17, 2009 For the more than 11 million Americans out of work, tax filing time can be a mixed blessing. For some, reduced income may mean a big refund check just when they need cash the most. For others, tax time can be shocking when they realize that the unemployment checks they have been receiving are taxable -- and they haven't had any taxes withheld.If you lost a good-paying job late last year, it could mean that you are still in the same tax bracket as when you were employed, says Mark Luscombe, principal federal tax analyst for CCH, a provider of tax information and software. For example, if you had an annual salary of $120,000 and were laid off in the fourth quarter after receiving $90,000, there's a good chance that you'll still be in the 28% federal tax bracket. Plus, any unemployment benefits you received in 2008 probably will be taxed at that 28% rate. "It may not seem fair given that you're not working, but the income tax rate is based on your total income, whether you earned it from salary or unemployment benefits," Luscombe says. Those who have been unemployed for a longer period probably will be in a lower tax bracket. But they, too, are required to report all income and pay taxes based on their overall income level. Although the new economic stimulus package excludes the first $2,400 of unemployment benefits from income taxes, it applies to benefits received in 2009. If you received unemployment benefits in 2008, you need to include them in your income when you file your 2008 return. Advertisement When you first begin receiving unemployment benefits, your state should inform you of your option to have state and federal income taxes withheld from your benefits. If you don't select the withholding option, you must estimate what you owe and file quarterly estimated taxes with the IRS and your state treasury department. If you don't, you may be subject to a late payment penalty as well as the outstanding taxes. However, you don’t have to pay FICA payroll taxes on your unemployment benefits. If you itemize your tax deductions, you may be able to write off some of the costs involved in looking for a new job, including expenses paid to a headhunter or job placement agency; transportation costs, parking and tolls when traveling to a job interview; and phone bills directly associated with your job search. Add up all of these costs and lump them together with your other miscellaneous expenses, such as investment fees and tax preparation costs, and deduct any amount in excess of 2% of your adjusted gross income. With a lower income, you may also be able to deduct medical expenses in excess of 7.5% of your AGI -- normally a very high hurdle to overcome. And you can tap your IRA or other retirement accounts penalty-free, to pay those medical bills in excess of 7.5% of AGI (but you'll still owe taxes on your withdrawals.) Sign Up: Get Tax Tips E-mailed to You Find more deductions with our Taxopedia. Plus see our Tax Center for all the tax information you need.