Is Unemployment Insurance Taxable Income?

Losing your job is one of the worst experiences you can have. Fortunately, most employees who lose their jobs are entitled to unemployment benefits. One thing that comes as a surprise to many newly unemployed people is that these benefits are generally taxable.

That's right, you have to pay income tax on your unemployment. It doesn't seem fair. But the IRS figures that people who receive unemployment benefits are getting wage income that is taxable.

What Unemployment Compensation Is Taxable

Taxable unemployment compensation generally includes, among other forms, state unemployment compensation benefits. But it includes other types of benefits as well, including disability payments from a government program paid as a substitute for unemployment compensation and unemployment assistance under the Disaster Relief and Emergency Assistance Act.

Also included are benefits paid to you as an unemployed member of a union from regular union dues. However, if you contribute to a special union fund and your payments to the fund are not deductible, you only need to include in your income the unemployment benefits that exceed the amount of your contributions.

If you contribute to a governmental unemployment compensation program and your contributions are not deductible, the amounts you receive under the program are not included as unemployment compensation until you recover your contributions. If you already deducted all of your contributions to the program, the entire amount you receive under the program is included in your income.

Should You Report Unemployment Compensation on Your Tax Return?

You must report unemployment compensation on your income tax return. You should receive a Form 1099-G, with the total unemployment compensation paid to you shown in box 1. Any federal income tax you elected to have withheld is shown in box 4. You should receive this form by January 31.

Income Tax Withholding from Unemployment Compensation

An important decision you must make is whether to have federal income tax withheld from your unemployment compensation. This process is similar to having payroll taxes withheld from your former paychecks. If you choose to do so, 10% of each payment will be withheld. To make this choice, complete Form W-4V, Voluntary Withholding Request, and give it to your unemployment agency. If you want to stop withholding, you must complete a new Form W-4V and give it to the payer.

Most people choose not to have any tax withheld. However, depending on your income for the year, your deductions, and how much you have already had withheld from your former job, you could end up owing income tax on your unemployment compensation come April 15. The IRS has an online withholding calculator you can use to determine how much you may need to have withheld from your benefits.

Do You Have to Pay Estimated Taxes?

If you choose not to have tax withheld, the IRS wants you to make estimated tax payments. You are supposed to pay estimated tax if you expect to owe more than $1,000 in income tax for the year.

However, if you paid no taxes last year—for example, because you were not working—you don't have to pay any estimated tax this year, no matter how much tax you expect to owe. You also don't have to pay estimated tax if the amount withheld from the salary from your former job will amount to at least 90% of the total tax you'll have to pay for the year.

Is Your Spouse Employed?

If you're married and your spouse has a job, you have another option: instead of having tax withheld from your unemployment compensation or paying estimated taxes, you can have your spouse adjust his or her withholding to cover the taxes due on your benefits.

Penalties for Not Paying Enough Tax During the Year

If you do not pay enough tax, either through withholding or estimated tax, or a combination of both, you might have to pay a penalty on the amount you underpaid each quarter. However, this penalty is fairly small, only about 3% interest. This means that it would be cheaper to pay the penalty to the IRS than to borrow money to pay your estimated taxes on time.

State Income Taxes

Forty-two states have state income taxes. Most of these states fully tax unemployment benefits. However, some only tax part of such benefits. Check with your state tax agency to find out its policy.