Do You Pay Taxes on Unemployment Benefits?

The US unemployment rate has reached historical highs and the numbers keep rising. According to the Department of Labor, 31.8 million people claimed benefits under all state and federal programs for the week ending July 4, 2020. The Department of Labor provides unemployment benefits to individuals who are unemployed due to “no fault of their own.” Also, eligibility requirements vary by state. Individuals need to understand taxes on unemployment benefits to avoid additional financial strain.  

Each state implements a separate unemployment insurance program. However, all of the states follow the guidelines established by federal law. The decision to levy taxes on unemployment also differs among states. 

Overall, there is no such thing as free money. The IRS views unemployment benefits paid by state and federal governments as income and taxes it accordingly. An individual receiving unemployment benefits needs to pay federal income taxes and state taxes as well in some jurisdictions. Unemployment benefits under the Pandemic Unemployment Assistance of the CARES (Coronavirus Aid, Relief, and Economic Security) Act are also taxable at an individual’s ordinary income tax rate.

States that do not tax unemployment benefits include Alabama, California, Montana, New Jersey, Pennsylvania, and Virginia. There are no taxes on unemployment benefits in seven states that do not levy any state income taxes. The states are Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. However, federal income tax may still be applicable.  

Individuals receiving unemployment benefits should include the benefits as part of their gross income. The taxes owed on benefits are due when individuals file their next income tax return. Most people who receive unemployment benefits are in a difficult financial position and need money to survive. However, not accounting for taxes on unemployment benefits could lead to more financial struggles and a large tax payment later.  

Many experts recommend that individuals submit a request for federal and state tax authorities to withhold taxes on unemployment benefits. Individuals can file a Form W-4V, which is also called a Voluntary Withholding Request. A federal tax rate of 10 percent can be withheld from each payment of unemployment benefits. The advantage of paying taxes upfront is that you avoid paying a big lump-sum amount at the end.

Another option is to make estimated tax payments quarterly on unemployment benefits. You can calculate the amount you owe or get an estimate from an accountant. However, you will have to pay a penalty if your estimate was lower than what you actually owe. In contrast, you will receive a tax refund if you paid more than what you owe. Form 1099-G, which is also called Certain Government Payments, reflects total unemployment benefits and the tax withheld on the benefits.     

Overall, individuals can choose how they prefer to pay taxes on unemployment benefits based on their situation. For unemployment benefits, you can submit a request for withholding taxes or make estimated quarterly payments to help avoid issues with your next annual tax return.