Do I Pay Taxes on Unemployment Benefits?

In this article...
  • Are unemployment benefits taxable? Find out whether you need to report unemployment earnings on your tax forms and how much you might owe for the year.
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Are Unemployment Benefits Taxable?

By law, unemployment insurance benefits count as taxable income. With very few exceptions, people who get unemployment benefits while they’re out of work must report their income on the next year’s tax return. Consider speaking with a tax professional to find out how much you owe and whether you have options to reduce your overall tax obligation.

Unemployment Benefits in 2020

The year 2020 saw record unemployment claims being filed. The historic downturn in the economy caused by lockdowns amid the coronavirus pandemic put tens of millions of people out of work for at least part of the year. For many of the people affected by the shutdown, 2020 was their first experience with filing for unemployment compensation.

What Is Unemployment Insurance?

Unemployment insurance is a government benefit that protects workers who find themselves out of work for whatever reason. Administered at the state level, but with significant federal funding, unemployment benefits pay a weekly award that may be spent like any other wages and can help keep you going until you’re back at work. The exact amount you get paid is determined by several factors, mainly the base rate of pay you earned during the previous year’s lookback period.

Once you’re approved for an unemployment award, the total amount you qualify for is divided by the number of weeks your state pays benefits for. Most states provide 26 weeks of compensation, though some go as low as 10 weeks and others as high as 30. When your benefits run out, you can request an extension, which may double the length of time you’re eligible to collect unemployment payments.

Withholding Taxes From Unemployment Compensation

Unemployment benefits are taxable, as if they were any other income, and you must report them on your tax return. Most state unemployment systems include an option to have taxes withheld from each check, as they would be from your regular paycheck. You have to opt into this, however, and many people choose not to because of the relative financial hardship losing a job imposes. Be aware that if you opt out of having taxes held back, you will likely have to pay that much more when the next year’s taxes are due.

Filing Your Taxes

Taxpayers in the United States are expected to file a tax return each year, usually between January 1 and April 15. The majority of people who earn money from employment file either IRS form 1040 or 1040EZ. These are the basic reporting forms that state how much money you earned in the previous tax year, what your exemptions, credits and deductions are and how much you owe or have already paid.

If you have opted into withholding deductions from each week's check, you have already been paying the IRS an amount that’s probably close to what you owe. If you have opted out of withholding, you are likely to owe a significant payment when you file. This is not always the case, however, since American tax laws contain a large number of money-saving rules that you can use to reduce the amount of taxes you owe.

Ways to Reduce Your Unemployment Tax Bill

The IRS calculates your overall tax obligation in a relatively simple way:

  1. Count up the money you earned over the year, from all sources combined except Social Security and child support.
  2. Reduce the amount of countable income for every exemption you have, such as a per-child exemption.
  3. Apply current progressive tax rates to this reduced amount of earnings to arrive at a number you owe.

Once you have your tax debt calculated in this way, you can reduce the amount you owe with credits and deductions. Of these, credits are more valuable, dollar for dollar, since the full amount of the credit goes directly toward reducing your taxes. Thus, if you have a $5,000 tax debt and a $2,000 child tax credit, your revised tax debt is $3,000.

Deductions are prorated for the tax bracket you are in. Thus, if your $2,000 in travel expenses are deductible, and you are in the 32% bracket, then you effectively get a credit for 32% of that $2,000, or $640. You can choose to either itemize your specific deductions, or you can take the standard deduction, which in 2020 runs from $12,400 for a single taxpayer to $18,650 for Head of Household filers, or $24,800 for married couples filing together. You cannot claim the standard deduction if you also itemize, so it pays to calculate how much you could save from all your deductible expenses, compare that with what the standard deduction could save you, and then go with the bigger number.

Negative Taxation for Unemployment Earnings

The 2020 economic downturn has created an odd environment for many taxpayers. Many people who were accustomed to earning high incomes and paying a lot in taxes suddenly wound up earning less, yet still having a built-up credit from the withholding taxes they paid early in the year. This can work out well for taxpayers reporting diminished earnings from unemployment benefits. If your exemptions, deductions and credits together add up to a figure that’s more than what you’ve already paid in taxes, you are probably entitled to a refund from the IRS. This is effectively a negative tax rate, and it can help out a lot for people who have recently lost their jobs.

For example, if you started 2020 earning $80,000 a year and paying $775 in taxes on your bi-weekly paychecks, then by the end of March, you probably paid $4,650 in taxes. If you then lost work because of COVID-19 and collected unemployment for the rest of the year, your total earnings may have been around $30,000. When you go to file your 2020 taxes, you might be able to take the standard deduction, claim exemptions and the child tax credit, and wind up owing negative-$2,000. In this case, the IRS will pay you back the money you overpaid from withholding.

Consult a Tax Professional

Tax laws are complicated, and only a tax professional can give you definitive advice about how to manage your filing obligations. Always seek the advice of a trusted professional before you make a major decision about whether or not to have taxes withheld from your unemployment checks, or how to go about reducing the amount of taxes you owe for your 2020 unemployment income.