The U.S. unemployment rate peaked in April 2020 at 14.8%—a level not seen since data collection began in 1948—before declining to a still-high 6.7% in December to close out the year.
That represents a lot of Americans who will find themselves grappling with taxes on their unemployment benefits during filing season in 2021 for 2020 tax returns. The good news is that up to $10,200 of those benefits received in 2020 are tax-free for those who earned less than $150,000 in modified adjusted gross income, thanks to the American Rescue Plan Act (ARPA) of 2021. After that point, however, unemployment benefits are taxable income.
The ARPA applies only to federal taxes, the return you'll file with the IRS in 2021. Several states have indicated that they're still going to tax unemployment benefits, so check with your state to find out how it plans to proceed.
Learn more about taxes on your 2020 unemployment benefits.
How Taxes on Unemployment Benefits Work
Unemployment benefits are income, just like money you would have earned in a paycheck. You’ll receive a Form 1099-G after the end of the year, which will report in Box 1 how much you've received in the way of benefits. The IRS will receive a copy as well.
You would have paid taxes on the full amount of your unemployment benefits if you filed your taxes before the ARPA was passed. The IRS issued a statement on March 31, 2021, urging taxpayers who had already filed not to file an amended return related to the new legislation. The IRS will recalculate and adjust all tax returns received prior to the ARPA that report unemployment income during the spring and summer of 2021 and will issue any resulting refunds.
You'll have to pay taxes on the remaining amount if you received more than $10,200 in unemployment compensation. Your 1099-G will have the information you'll need to transfer to your tax return.
Unemployment compensation has its own line (Line 7) on Schedule 1, which accompanies your 1040 tax return. You’ll transfer the amount in Box 1 of Form 1099-G to Line 7 of Schedule 1, and then the withholding amount (if any) in Box 4 of the 1099-G goes directly onto your 1040 tax return on Line 25b.
The amount that was withheld will appear in Box 4 if you asked to have income tax withheld from your benefits.
You must still report your unemployment compensation on your tax return, even if you don’t receive a Form 1099-G for some reason.
Effect on Other Tax Benefits
Taxable unemployment benefits include the extra $600 per week that was provided by the federal government in response to the coronavirus pandemic, accountant Chip Capelli, of Provincetown, Massachusetts, told The Balance.
Not only is unemployment compensation taxable, but receiving it can also affect some tax credits you might be eligible for and are counting on to defray those 2020 taxes that will be due.
“Something else to consider is if you usually get the Earned Income Credit (EIC) each year,” Capelli said. “While unemployment benefits aren’t considered ‘earned income,’ they do influence your adjusted gross income (AGI), which is used to calculate the EIC.”
The American Rescue Plan Act also expanded eligibility for the EIC to include more households, including childless households, as well as increasing the maximum credit from $543 to $1,502.
Income Taxes vs. FICA Taxes
Unemployment compensation is not subject to FICA taxes, the flat-percentage Social Security and Medicare taxes that would normally be withheld from your paycheck if you were working.
You'll still pay significantly less in FICA taxes than you would have had you been working if you collected unemployment through a significant part of the year.
State vs. Federal Taxation
You’ll get even more relief if you live in a state that doesn’t tax unemployment benefits. Otherwise, you’ll owe tax on your benefits to both the IRS and your state government.
As of 2020, the states that don’t tax unemployment benefits are:
- New Jersey
An additional eight states don’t tax any income at all, so you'll catch a break here as well:
- South Dakota
New Hampshire has an income tax, but only on investment income, so you’ll pay less tax if you live in that state, too. And two more states—Indiana and Wisconsin—may tax only a portion of your benefits, Capelli said, but he warned that some cities and counties have local income taxes that will apply to unemployment compensation as well.
Do I Have to Pay Taxes on the Extra $600?
The Coronavirus Aid, Relief, and Economic Security (CARES) Act provided for the Federal Pandemic Unemployment Compensation (FPUC) program when President Trump signed it into law on March 27, 2020. It provided an additional $600 per week in unemployment compensation per recipient through July 2020. That money is also taxable after the first $10,200.
You might be paid up if you arranged to have income tax withheld from your benefits, but federal law caps withholding on benefits at 10%. That might not be enough to offset all taxes owed if you had additional income during the year.
Not all states were technologically prepared to withhold anything from that extra $600 portion. Their unemployment systems simply weren’t up to the task, and many initially collapsed during the first weeks of increased visits to their sites.
You'll still have to pay tax on benefits you received over $10,200 if you asked for withholding and it didn't happen.
This 10% withholding cap prevents you from having extra money withheld now to try to compensate for not having anything withheld earlier in the year. You can ask for extra withholding from your paychecks, however, if you return to work.
How to Prepare for Your 2020 Tax Bill
Contact your unemployment office immediately if you do owe tax on your unemployment benefits and are concerned about being able to pay. You can start having income tax withheld from your payments if you haven’t already done so and if you’re still collecting.
“If you’re still collecting unemployment benefits, see if you can opt in to having federal and state taxes withheld,” Capelli said.
It probably won’t solve your whole problem with the 10% withholding cap in place, but it will somewhat defray the impact of those benefits being included in your income. Ask for Form W-4V, fill it out, and file it with your unemployment office.
If You Owe Tax You Can’t Pay
Many Americans find themselves in a position where they still need every cent of those unemployment checks for living expenses, in which case there’s no money left to send to the IRS for quarterly estimated tax payments. You might still have options if this is the case.
The IRS suggests paying what you can and reaching out to take advantage of one of its payment options to deal with the balance. You can ask for an installment agreement and pay off your tax debt on balances of up to $50,000 over 72 months, according to Capelli.
Making the request is a simple matter of filing Form 9465 with the IRS. This will at least cut the 0.5% per month late-payment penalty to 0.25%, although the effective interest rate will continue at 3% (as of the second quarter of 2021).
You might also look into an offer in compromise to settle your tax debt for less than the full amount you owe, or ask the IRS for a temporary delay in collecting if your financial situation is particularly difficult. But you’ll almost certainly need the help of a tax professional to exercise either of these options.
Capelli strongly recommended against taking out a loan to pay your tax bill except as a last resort.
“Do not, under any circumstances, borrow money unless it’s interest-free,” Capelli said. “Don’t use a credit card to pay your taxes. The IRS interest rate is lower than most credit cards, and the IRS payment plan doesn’t appear on your credit report.”
Frequently Asked Questions (FAQs)
How much taxes are taken out of unemployment compensation?
The person receiving benefits can choose whether or not to withhold taxes from unemployment payments. If they do not withhold taxes directly from the compensation, they will either have to make quarterly estimated payments or settle their tax liability the next time they file returns.
What happens to the amount of tax money the government collects if unemployment is high?
A period of persistently high unemployment could be expected to reduce the amount of money the government collects in taxes. Of course, national taxation is a complex system that's always subject to shifts in political winds and economic forces. If a government wasn't collecting enough revenue, it could theoretically change the tax code as needed to make up for those losses.
Who pays unemployment taxes?
Taxes on unemployment benefits are paid by the person receiving the benefits. However, "unemployment taxes" could also refer to taxes imposed by the Federal Unemployment Tax Act (FUTA). FUTA taxes are paid by employers.