Don’t Forget to Pay Income Tax on Your Unemployment Benefits—Here’s How

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If you are receiving unemployment benefits, you should know that those benefits are considered income and are therefore taxable. You may need to make a plan for paying the additional income tax so that you won’t face a large, surprise tax bill next April. This is always an issue facing people who receive unemployment benefits, but the situation is more confusing than usual in the midst of COVID-19.

The CARES Act created the Federal Pandemic Unemployment Compensation (FPUC) program, which provides additional unemployment insurance to Americans who are out of work. This additional income is also taxable, adding to the tax liability for those receiving unemployment. Also, states handle taxes on unemployment income differently, and some states have struggled to incorporate FPUC into their normal unemployment processes. In this article, we will explain the basics of how these benefits are taxed and what you can do to make the tax burden more manageable.

The Basics

Money you receive as an unemployment benefit is considered to be “income.” Therefore, it is usually subject to the same tax requirements as income. However, unemployment is not subject to “payroll taxes,” which include the taxes for Social Security and Medicare that are usually withheld from your paycheck.

One complication is that unemployment is taxed differently at the federal and state levels. Everyone owes federal income tax on their unemployment benefits. But state income tax is different. Some states do not have income tax, and therefore the unemployment benefits are not taxed by these states. This includes Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. It also includes New Hampshire and Tennessee, though they technically have an income tax for investment income. If you live in one of those 9 states, you should not owe tax on your unemployment benefits. Other states do not collect income tax on unemployment benefits even though they have a general income tax. This includes Alabama, California, Montana, New Jersey, Pennsylvania, and Virginia. If you live in one of those six states, unemployment benefits should be excluded from state income tax.

If you don’t live in one of the 15 states that doesn’t tax unemployment benefits, then you need to have a plan to pay the state tax you will owe. And remember, everyone needs to make a plan for paying the federal tax they will owe.

Three Options to Pay the Tax

The most straightforward way to pay your income tax while you receive unemployment is to have your state unemployment office withhold it. This works similarly to when you are receiving a paycheck from an employer and some of your income taxes are taken out. You should have the opportunity to make this election when you first apply for unemployment. If you are already receiving unemployment and did not make the election to have taxes withheld, you can contact your local unemployment office to request withholding of federal taxes and state taxes (if any). You will need to fill out a Form W-4V, and then file that with the unemployment office. Note: only 10 percent of each unemployment payment may be withheld for federal taxes; no other amount is allowed.

Another option is to pay quarterly estimated tax payments. This may be required in order to avoid penalties for failing to pay enough tax during the year, if you do not have the tax withheld. You can read the IRS guidance about quarterly estimated tax payments, but you should know that this option is fairly “high maintenance” compared to having the tax withheld. You would have four deadlines to worry about throughout the year and have to submit payments separately to the state and federal government. It is probably best to avoid this option if you can help it.

The third option is to pay the tax in full when it is due. This may not be a bad solution if you received unemployment for a brief time. However, it can create increased tax liability if you were supposed to pay tax throughout the year (either through withholding or quarterly payments) and failed to do so. This could also leave you facing a very large bill in April that you may not have the means to pay if you have not been saving money to do so.

One Complication: Federal Pandemic Unemployment Compensation (FPUC) Withholding

There is one complication that is affecting a few states’ ability to properly withhold taxes from unemployment payments, and you should know about it so you can plan accordingly.
The CARES Act created the Federal Pandemic Unemployment Compensation (FPUC) program. This is the program that provides an additional $600 to those collecting unemployment. Some states struggled to incorporate this program into their existing unemployment systems. The result? Some states have been unable to withhold taxes from the $600 coming from FPUC, even though they are required to do so. For example, New Jersey has faced this problem. This means that some consumers may not have an adequate amount of tax withheld and could have tax liability at the end of the year. If you live in a state with this issue, you should contact your unemployment office for guidance, and you may need to file quarterly estimated tax payments.

Bottom Line

Unemployment benefits are taxable. They are taxable for everyone at the federal level, and for most people at the state level. Be sure to know how your state handles income tax for these benefits. And, we recommend you contact your state unemployment office to ensure that your federal and state (if any) taxes are automatically withheld from your unemployment checks. Taking a few simple steps now might save you from a major headache and expensive bill later.