Unemployment and Taxes: How to Pay Taxes on Unemployment Benefits

Due to economic shutdowns caused by the coronavirus pandemic, millions of Americans have lost their jobs and had to file for unemployment benefits — many for the first time ever. 

About 884,000 people filed unemployment claims during the week of August 31, according to the U.S. Labor Department. This is nearly four times higher than average weekly unemployment claims before the pandemic began.

Unemployment and Taxation

Some of these individuals have been surprised to learn that their benefit payments are taxable at the federal, and usually also the state, level. In fact, federal unemployment benefits have been taxable since passage of the Revenue Act of 1978. This change was passed in an effort to discourage recipients of unemployment benefits from becoming too reliant on them instead of seeking a job.

Like wages, unemployment benefits are taxed as ordinary income to the recipient, though Social Security and Medicare taxes aren’t levied. The payments are reported on Form 1099-G, which is mailed to recipients from state unemployment departments in January. States are required to let unemployment recipients know that they’ll be responsible for paying income tax on the benefits.

How to Pay the Tax

To avoid having an additional tax bill when you file your tax return next year, you can have federal and state taxes automatically withheld from your benefit payments just like they’re withheld from your salary. To do so, file IRS Form W-4V, Voluntary Withholding, with your state unemployment office. 

Note that you can only elect to have 10% of the benefit amount withheld for federal income taxes. Depending on your total income for the year, this may not be enough to cover your total tax liability. In this case, you might want to pay quarterly estimated taxes to make up the difference. 

Conversely, if your finances are tight right now, you might choose to preserve cash flow and hold off on having taxes withheld or making quarterly estimated tax payments. But keep in mind that this could result in having to pay penalties and interest when filing your 2020 tax return next year if you underpay your taxes.

Keep Track of Your Income

To avoid an unpleasant tax surprise, it’s a good idea to keep track of your total income throughout the year in order to gauge your potential tax liability for the year. For example, if you return to work later this year, factor this into your income projections for the year. You can have additional money withheld from your paycheck if necessary to cover the income tax due on your unemployment benefits, or pay quarterly estimated taxes later in the year.

Give us a call if you have more questions about taxation of unemployment benefits. We can help you devise the best tax payment strategy given your current financial situation.