As the coronavirus halted operations for businesses across the country, millions of employees were suddenly furloughed or laid off from their jobs. Others had their hours significantly cut, leaving them underemployed. Within a span of six weeks, a staggering 30 million people applied for unemployment benefits.
Maybe that includes you. Unemployment insurance can help keep you afloat until you find a new job, especially the expanded benefits under the CARES Act. But what you might not realize is that you don’t get to keep all the money you receive. Unless you take steps now to have taxes withheld from those unemployment payments, you’ll be responsible for reporting and paying the taxes yourself. And if you don’t pay enough of that tax bill this year, you could be charged a penalty next year for underpaying your taxes.
Fortunately, you can avoid this situation by learning how to handle income tax on unemployment benefits. Here’s what you need to know.
Yes, Unemployment Benefits Are Taxable
Unemployment insurance is a joint state-federal initiative. Each state administers its own benefits program, but all states follow guidelines set forth by the federal government. If you receive unemployment benefits, the money is considered income by the Internal Revenue Service.
“Unemployment compensation is generally still subject to income tax, along with any other income you made during the year, such as wages, interest, dividends, retirement distributions, etc.,” said Christina Taylor, head of operations at Credit Karma Tax. “If you don’t pay enough toward your income tax obligations, you could end up with a tax bill ― and possibly penalties and interest ― when you file your tax returns in 2021.”
Both the federal government and most state governments require you to pay income taxes on unemployment benefits ― with the few exceptions including California, Montana, New Jersey, Pennsylvania and Virginia. You are not required, however, to pay Social Security or Medicare taxes on these benefits.
If you receive unemployment payments at any point during the year, you will get a Form 1099-G at tax time from your state government. This document reports certain government payments you received, including unemployment; state or local income tax refunds, credits or offsets; taxable grants; and more. When it comes to unemployment benefits, you can see the total amount of compensation you received for the year in Box 1, as well as any federal tax withheld (Box 4) and state tax withheld (Box 11).
Bear in mind that other types of unemployment funds that don’t come from the state or federal government might not be fully taxable. For example, if you contributed to a non-union unemployment fund through your job and then later received payments from that fund, only the money that exceeds the amount you contributed would be taxable.
Options For Paying Unemployment Tax
Though your unemployment benefits are taxable, the government doesn’t automatically withhold taxes from those checks as it does with a regular W-2 paycheck. That means you have to take action to pay those taxes on your own. You have a few options:
Request to have taxes withheld. “The U.S. tax system is a pay-as-you-go system, so individuals are expected to pay taxes throughout the year,” said Mark Jaeger, director of tax development at TaxAct. Usually, federal and state withholding on regular W-2 income from an employer satisfies that requirement.
You can request to have taxes similarly withheld from your unemployment payments when you apply for them or by filing a Form W-4V with your state unemployment office. “Some states only allow a person to withhold a standard 10% for federal taxes,” Jaeger said, so keep this in mind when planning for your 2020 taxes.
Make quarterly estimated tax payments. If you didn’t request to have taxes withheld from your unemployment compensation, you can still make quarterly estimated tax payments throughout the year. This involves doing some calculations to figure out how much tax you owe so far, based on your income for each quarter, and then paying it ahead of the April 2021 deadline. If you end up paying too much (or too little), the difference will be reconciled when you file your official tax return.
Pay up in April 2021. Finally, you can simply wait until you complete your return for the year 2020 and pay your tax bill when you file. However, you will likely end up having underpaid your taxes this way, which will result in a penalty if you owe more than $1,000 for the year.
Even so, having your taxes withheld or making estimated payments means getting a smaller check now when you need the money most. If you’re really strapped for cash, it might be worth paying a small penalty later to avoid giving up a portion of your benefits to taxes now. Jaeger also noted that if you do get a job before the end of the year, and your financial situation allows it, you can have your employer withhold extra money from your paycheck to help cover the taxes on that unemployment compensation.
Deciding which action to take depends on your financial situation and total income for the year.
Whatever payment option you choose, you should plan for how claiming unemployment will impact your tax bracket and the total taxes you owe. Note, for example, that individuals who qualify for unemployment insurance benefits are eligible for an additional $600 per week under the CARES Act.
“That additional $600, on top of any other unemployment received from the state, is considered taxable income and it adds up fast,” Taylor said. “For example, the extra $600 alone adds up to $9,600 in income if you collect this benefit for the full 16-week period.”
And don’t forget the income tax you may owe on any wages earned before losing your job this year or any other taxable income you receive.
What About Stimulus Payments?
If you received a direct payment from the federal government as part of the coronavirus relief package, you might be wondering if you have to pay taxes on that. The answer is no. Unlike unemployment insurance, the relief payments are not considered taxable income. You will, however, need to report this payment on your 2020 tax returns so that it can be reconciled against your income and tax information for the year.
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