Do You Have to Pay Taxes on Unemployment Income?

The answer is usually yes

People standing in line at Job and Training Fair

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It's a natural question if you've lost your job and you’re faced with preparing your tax return, a dilemma many taxpayers will face as 2021 dawns: Are your unemployment benefits considered taxable income? In most cases, the answer is yes. 

The Internal Revenue Service (IRS) reminds taxpayers that there are different types of unemployment compensation, and most are taxable. This includes that extra $600 per week you might have received in 2020, provided for under the CARES Act due to the coronavirus pandemic. 

The IRS offers an interactive tool on its website to help you determine whether the income you receive while you're unemployed is taxable. You can take some steps to pay throughout the year if it is so you can avoid owing the IRS taxes or penalties at tax time.

The federal government expanded access to unemployment insurance in March 2020, covering workers who were previously ineligible if they were affected by the coronavirus. More taxpayers might find themselves facing this dilemma in 2021 as a result. 

How Do Unemployment Benefits Work?

Unemployment is a benefit paid by state or federal governments to help people who have lost their jobs through no fault of their own. It doesn't apply if you quit or were fired for cause.

You would contact your state's unemployment insurance program to apply for unemployment benefits. Certain limitations apply as to the amount you're eligible to receive, and they can vary by state. For example, New Jersey provides benefits of up to 60% of your average pay, capping out at $713 a week as of 2020, not including the extra $600 provided for under the Coronavirus Aid, Relief, and Economic Security (CARES) Act.

Unemployment taxes are paid by employers and these taxes go into a state fund to aid workers who have lost their jobs. The U.S. Department of Labor monitors the system.

Withholding Taxes From Unemployment Compensation

The IRS views unemployment compensation as income, and it generally taxes it accordingly. You can elect to have federal income tax withheld from your unemployment compensation benefits, much like income tax would be withheld from a regular paycheck.

Unfortunately, you don't have a choice as to how much you want to be withheld. Federal income tax is withheld from unemployment benefits at a flat rate of 10%. Depending on the number of dependents you have, this might be more or less than what an employer would have withheld from your pay.

You can use Form W-4V, Voluntary Withholding Request, to have taxes withheld from your benefits. Complete the form and give it to your unemployment office.

Making Estimated Tax Payments

You might be required to make payments directly to the IRS as quarterly estimated tax payments if you elect not to have taxes withheld from your unemployment benefits. This works out to a payment once every three months while you're collecting unemployment benefits instead of having 10% withheld from every unemployment check. Doing it this way might give you a little bit of wiggle room when money is tight.

You might even have to make quarterly payments in addition to withholding from your benefits. In most cases, you're obligated to make estimated payments if you expect that you'll owe at least $1,000 after accounting for all taxes withheld from all your sources of income, and if you expect that your withheld taxes plus any refundable tax credits you're eligible for will be less than 90% of what you'll owe or 100% of the total taxes you paid last year. You might easily hit these thresholds when the extra $600 CARES Act payment is added in.

You might want to consult with a tax professional because the whole equation can be complicated. You could accrue additional penalties if you don't pay enough tax, either through withholding or estimated tax payments.

Reporting Unemployment Income for Taxes

Your state's unemployment agency will report the amount of your benefits on Form 1099-G. The IRS gets a copy, and so do you. The form will also show any taxes you had withheld.

You must report these amounts on line 7 of the 2020 Schedule 1, then total all your sources of additional income in Part I of the schedule and transfer the number to line 8 of the 2020 Form 1040.

The economic impact payment or stimulus check that you might have received in 2020 in response to the coronavirus is not considered to be unemployment compensation. You do not have to pay taxes on this money.

The Bottom Line

Ultimately, your unemployment income will be taxed right along with any other income you might have earned during the year. Use Form W-4V to withhold any tax from your unemployment income, or pay quarterly taxes to ensure you don't owe the government any penalties come tax season. And always consider working with a tax professional if you have questions about your specific situation.