Are unemployment benefits taxable? | The motley madman

The COVID-19 pandemic put millions of people out of work in early 2020. Even though some people have managed to return to their jobs, many still rely on unemployment benefits for financial support.

With tax season expected to start in mid-February, many people who received unemployment checks in 2020 are about to get a nasty surprise. When you prepare your federal income tax returns for 2020, you will need to report these unemployment benefits as income to the IRS and likely pay taxes.

How Unemployment Checks Are Treated For Federal Taxes

The federal definition of gross income includes the money you receive in the form of unemployment insurance benefits. The general idea is that if you were working, the money you would receive in the form of a salary or wages would be taxed. Therefore, the money you get instead of working should be treated the same.

The IRS will collect taxes on unemployment assistance, whether it comes from federal or state unemployment insurance funds. Additional support from special unemployment programs is also usually included.

The only exception is if your employer has created a private fund to which you are required to make contributions from your own salary. In this case, you don’t have to pay tax, assuming that what you get is less than what you put into the fund. However, if your benefits exceed your contributions, you will have to pay the excess at tax time.

A break from social charges

Given the IRS’s position on how unemployment benefits are like wage income, you might reasonably think that the tax agency would hit you for payroll taxes to support Medicare and Social Security as well. However, these social charges do not apply to unemployment checks.

You generally won’t have an additional 7.65% taken out of your federal or state unemployment benefits. If your company offers its own private fund for supplementary unemployment benefits, these benefits may be subject to deduction. In this case, consult your employer’s human resources department for more information.

Take a double hit

If your state charges its own income tax, you will likely have another tax bill owing on your unemployment checks. Only a few states, including Alabama, California, Montana, New Jersey, Pennsylvania, and Virginia, have special provisions making unemployment benefits exempt from income tax.

Also, even if you are taxed as if the money you receive were income, you cannot treat it as earned income for tax purposes. The biggest problem is that unemployment benefits don’t count in determining how much you will receive from the federal working income tax credit. For many struggling low and middle income taxpayers, the earned income tax credit offers thousands of dollars in tax relief. But even when you need it the most, unemployment benefits don’t give you extra credit.

Be ready

Dealing with taxes when you’re out of work may seem unfair, but it’s important to be prepared.

You can usually have money withheld from your unemployment check to pay taxes. This way, the money you owe is never in your hands. Otherwise, you may need to make estimated quarterly tax payments in order to avoid penalties.

It might seem crazy to withdraw money from your checks when you need every dollar you can get. Yet knowing the rules allows you to avoid the much larger problem of a huge, unexpected tax bill in April.