The COVID-19 pandemic left millions of people out of work in early 2020. Although some people have managed to return to their jobs, many people still rely on unemployment benefits for financial support.
As the tax season begins in mid-February, many people who received unemployment checks in 2020 will get a nasty surprise. When preparing your federal tax returns for 2020, you should report the unemployment benefits as income to the IRS and probably pay taxes on them.
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How Federal Tax Unemployment Checks Are Treated
The federal definition of gross income includes money you receive as benefits from unemployment insurance. The general idea is that if you work, the money you would receive as a wage or salary would be taxed. Therefore, money you receive instead of work should be treated in the same way.
The IRS will levy taxes on unemployment benefits, regardless of whether they come from federal or state unemployment insurance funds. Further support for special unemployment programs is usually also included.
The only exception is if your employer has created a private fund to which you have to contribute from your own payment. In that case, you do not have to pay tax, if you accept that it is less than what you paid to the fund. However, if your benefits exceed your contributions, you will be liable for the co-payment at tax time.
A break in payroll tax
Given the IRS’s position on how unemployment benefits such as wage income are, you would reasonably think that the tax agency would pay you for tax payments to also support Medicare and Social Security. However, this payroll tax does not apply to unemployment checks.
You will not normally take 7.65% extra from your federal or statelessness benefits. If your company offers its own private supplementary unemployment benefit fund, it can be withheld. In this case, consult your employer’s HR department for more information.
Take a double hit
If your state levies its own income tax, you’ll probably have another tax bill to pay on your unemployment checks. Only a few states, including Alabama, California, Montana, New Jersey, Pennsylvania, and Virginia, have special provisions that exempt unemployment benefits from state revenue.
Even though you are taxed as if the money you receive is income, you cannot consider it as tax income as earnings. The biggest problem with this is that unemployment benefits do not compete to determine how much you will receive from the federal income tax credit. For many struggling low- and middle-income taxpayers, the earnings tax credit offers thousands of dollars in tax relief. But even at a time when you need the most help, your unemployment benefits are not getting extra credit.
Be right
Dealing with taxes when you are unemployed may seem unfair, but it is important to be prepared.
You can usually withhold money from your unemployment check to go to tax. This way, the money you owe in the first place is never in your hands. Alternatively, you should make quarterly estimated tax payments to avoid fines.
It may sound crazy to have money taken out of your checks if you need every dollar you can get. Knowing the rules, however, helps you avoid the much bigger problem of a large unexpected tax bill in April.