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Do you have to pay taxes on unemployment benefits? The answer may surprise you! Find out what you should know before tax season rolls around.
The outbreak of coronavirus has left millions of Americans unemployed and relying on unemployment benefits. Expansions of the unemployment system through the CARES Act and Pandemic Unemployment Assistance program have helped some weather the storm. Still, the more than 36 million Americans who have filed for unemployment benefits are experiencing significant economic uncertainty.

One question on many people’s minds is whether unemployment benefits are taxable, and if they are, how they should be paying those taxes.

Do You Have to Pay Taxes on Unemployment Benefits?

Yes, unemployment benefits are considered taxable income, much like income that you earn from working.

Thanks to the CARES Act and PUA, Americans are receiving much more in unemployment benefits than they did previously. Where the average weekly unemployment benefit was $387, it is now closer to $1,000. That leaves people out of work with much more money to pay their bills, but a potentially higher tax bill.

Unemployment income is considered income, which means that it is subject to the federal income tax. If your state has an income tax, you also have to pay income tax to your state government.

On the bright side, because you don’t receive the income from an employer, you do not have the Social Security and Medicare taxes that you typically pay on income earned from working at a job. This saves you about 7.65% compared to the taxes you typically pay.

At the end of the year, your state unemployment office will send you Form 1099-G which outlines the unemployment benefits that you received. You’ll need to include the information on this form when you file your tax return.

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How Do You Pay Taxes on Unemployment Benefits?

You have the choice of how to pay your income taxes on unemployment benefits, though each choice has pros and cons.

Withholding From Your Benefits

Possibly the easiest way to pay the taxes you owe on your unemployment income is by having the government withhold a portion of your unemployment check, just like an employer would.

When you get a paycheck from work, your employer automatically withholds some of your income to pay taxes and other purposes. If you earn $2,000 per paycheck, you might only get $1,500 deposited to your account because your job withholds the other $500 for taxes.

At the end of the year when you file your tax return, you include information about how much you paid through withholding and determine whether you owe money or paid too much and should get a refund.

Withholding from your unemployment check is similar to employer withholding. You can fill out form W4-V to request that your state unemployment office withhold a portion of your benefit for taxes.

If you fill out and submit the form, the state will automatically withhold 10% of your benefit to pay federal taxes. The withholding rate varies from state to state.

The upside of this strategy is that this makes paying taxes easy and automatic.

The downside is that this means you get less money in your pocket, precisely when you need it the most. You have to pay the taxes eventually, but sometimes the extra cash is important, and parting with 10% of your unemployment check can be difficult.

Another thing to consider is that the federal income tax rate ranges from 10% to 37%. If you fall into one of the higher tax brackets, withholding at 10% might not fully cover your tax bill.

Related: Federal Income Tax Brackets and Standard Deduction

Quarterly Estimated Payments

People who don’t work for a typical employer, including the self-employed and freelancers, don’t have an employer to withhold their income and send payments to the IRS. These types of workers instead send estimated tax payments to the IRS each quarter.

If you’re receiving unemployment benefits, you can file estimated tax payments to make sure you pay the taxes that you owe.

You can use form 1040-ES to calculate the amount that you’ll owe so that you can properly make your estimated tax payments. This lets you pay precisely the amount that you owe and doesn’t reduce the size of your benefits upfront.

On the downside, figuring out your estimated taxes can be complex. There’s also no guarantee that you’ll do it correctly, so you might wind up over or underpaying by accident. If you underpay, you’ll still have a tax bill at the end of the year.

Pay at the End of the Year

The third option for paying taxes on your unemployment benefits is waiting until you file your tax return at the end of the year.

The upside of waiting to file your tax return is that you can keep all of your benefits to pay for immediate living expenses. There’s also no risk of over or underpaying since you’ll know exactly the amount that you owe in taxes.

One of the drawbacks of waiting until you file your tax return is that you will have to pay all of the tax in one lump sum. This can be expensive and you might not have enough money saved up to cover the large bill, especially if you’re out of work for a long period.

Another drawback is that you may be subject to penalties. The IRS applies a penalty to anyone who owes more than $1,000 unless they either paid at least 90% of the tax bill or 100% of the amount they owed the previous year.

What Happens If You Don’t Pay Taxes on Unemployment Benefits?

Failing to pay taxes on your unemployment benefits is just like not paying taxes on other forms of income.

If you don’t pay taxes on your unemployment income and wait until filing your tax return, you might get hit with a penalty from the IRS if you wind up owing more than a certain amount.

If you don’t file your taxes, or file and don’t include your unemployment income in your tax return, several things can happen.

First, if you fail to file your return, you’ll start to incur a failure to file penalty of 5% per month, up to a total of 25%. If you file your tax return but don’t pay your bill, you’ll pay a penalty of 0.5% per month, up to a maximum of 25%.

You also have to pay interest on unpaid taxes. The interest rate is equal to the federal short-term interest rate, plus 3%. Combined, the penalties can’t exceed 5% per month, but that is still a significant penalty to pay.

Even if you can’t pay taxes you owe on unemployment benefits, you should still file your tax return to avoid the penalty for failing to file. The IRS is generally willing to work with taxpayers who need additional time to pay the taxes they owe. File your return and reach out to the IRS to set up a payment plan.

Bottom Line

The coronavirus pandemic has made life difficult for millions of Americans. Understanding how taxes affect your unemployment check can help you avoid more financial difficulty down the road.

For most people, having your local unemployment office withhold taxes will be the easiest way to avoid tax difficulties in the future. However, knowing all of your options is important because it lets you choose the best course of action for your situation.

Author Bio

Total Articles: 9
TJ is a Boston-based freelance writer who specializes in credit, credit cards and bank accounts. In his spare time, he enjoys reading, writing, cooking, playing games (of the video and board varieties), soccer, and ultimate frisbee. You can find his work on his website, tjporterwriting.com.

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