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Unemployment benefits can be a financial lifeline when you lose a job, but you should know that the IRS considers them taxable income.
As such, you may need to have income taxes withheld from your benefits, make estimated payments or create a plan for paying the amount you’ll owe when you file your federal income tax return.
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How Are Unemployment Benefits Taxed?
Unemployment benefits are designed to replace a portion of your regular wages. As such, the IRS treats them like any other wages and taxes them at your ordinary income tax rate.
Whether you’ll actually owe taxes on unemployment benefits, and the rate you’ll pay, depends on your overall tax situation and tax bracket.
The state that paid your unemployment benefits should send you a Form 1099-G showing how much unemployment income you received and how much (if any) taxes it withheld.
How To Pay Federal Income Taxes on Unemployment Benefits
Perhaps the easiest way to pay taxes on unemployment compensation is to have federal income taxes withheld from your weekly payments. To have federal income taxes withheld, file Form W-4V with your state’s unemployment office so it will withhold taxes.
If you request tax withholding, the state will withhold 10% of each payment—no other amounts or percentages are allowed.
Another option is to make estimated quarterly payments by mailing a check with IRS Form 1040-ES or making a payment online via IRS Direct Pay. However, this option is fairly high-maintenance compared to having tax withheld from your unemployment benefits.
First, you need to estimate the amount you’ll owe using your tax software or the worksheet accompanying Form 1040-ES. Then you need to make four quarterly payments, generally due April 15, June 15, Sept. 15 and Jan. 15 of the following year.
The final option is to wait until you file your tax return to see how much you’ll owe. However, this option can be risky because it can leave you with a large tax bill and underpayment penalties in April.
State Income Taxes on Unemployment Compensation
You may also need to pay state income taxes on your unemployment benefits. This is another tricky area because each state has different rules. Some states don’t have a state-level income tax, and others don’t tax unemployment benefits. Some tax unemployment benefits in full, and others impose taxes on only a portion of benefits.
If you live in one of the eight states that don’t have a state income tax (Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington and Wyoming), you don’t have to worry about paying state income taxes on your benefits. New Hampshire residents are also in the clear because the state only taxes interest and dividend income.
California, New Jersey, Pennsylvania and Virginia don’t tax unemployment benefits, so residents in those states don’t have to worry about state-level withholding, either.
If you live in any of the other 37 states or the District of Columbia, check with your tax advisor or your state’s tax agency to find out how unemployment benefits are taxed. Those states should allow you to set up state withholding online when you apply for unemployment or at any point while you are receiving benefits.
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On Nov. 1, the IRS announced it had sent about 430,000 tax refunds to taxpayers who overpaid taxes on their unemployment in 2020. If you claim unemployment and qualify for the adjustment, you don’t need to take any action. You’ll receive your refund by direct deposit if the IRS has your banking information on file, and a paper check if not.
These taxpayers are getting a refund because they had already reported their unemployment compensation on their 2020 tax returns before the American Rescue Plan (ARP) was signed into law. ARP provided a tax break of up to $10,200 to those who received unemployment compensation in 2020.
To date, the IRS has identified more than 16 million taxpayers who are eligible and has issued more than 11.7 million unemployment tax refunds, totaling $14.4 billion. Although the IRS started processing the unemployment tax refunds in May, it started with the simplest tax returns and is now processing the remaining tax returns. The IRS will continue to process these tax returns before the end of the year.
The IRS plans to continue to send more refunds to qualifying taxpayers through the end of 2021. Here is what you need to know.
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Who Qualifies for the $10,200 Unemployment Tax Break?
You may qualify for the tax break up to $10,200 of unemployment compensation if your modified adjusted gross income (MAGI) is less than $150,000 for 2020. If you’re married, each qualifying spouse may exclude up to $10,200.
If your MAGI exceeds the income threshold, you won’t qualify for the tax exclusion and will need to pay taxes on any unemployment compensation you receive. Also, if you file Form 1040-NR, you can’t claim the unemployment tax break for your spouse.
If you have yet to file your 2020 tax return, you can claim the tax break up to $10,200 from your taxable income.
You May Now Qualify for Other Tax Breaks
The IRS will automatically adjust your tax return if you qualify for the unemployment tax break, which may affect your eligibility for the Earned Income Tax Credit, Additional Child Tax Credit, American Opportunity Tax Credit, Premium Tax Credit and the Recovery Rebate Credit on your tax return.
If you didn’t claim the Earned Income Tax Credit or the Additional Child Tax Credit, but may now be eligible for them, the IRS will send notices by mail requesting additional information to determine if you qualify. Once they receive your response, the IRS will make the necessary adjustments to your tax return, although they haven’t yet disclosed how they’ll send refunds if applicable.
However, if you now qualify for other tax benefits, such as the tuition and fees deduction and the student loan interest deduction, you’ll need to file a Form 1040-X, Amended U.S. Individual Income Tax Return to claim them. Use the IRS’ interactive interviews to determine if you qualify for any additional tax breaks, or speak with a tax professional.