Is Unemployment Insurance Taxable Income?

It may seem surprising and unfair, but unemployment benefits generally are taxable.

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

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.

Special Rules for 2020 Unemployment Payments

Due to the mass layoffs caused by the COVID-19 pandemic, over 40 million Americans received unemployment benefits during 2020. To provide them with tax relief, Congress enacted a special rule exempting from federal income tax up to $10,200 in unemployment benefits paid during 2020. If you and your spouse both received unemployment during 2020, $10,200 to each of you is tax-free, for a total of up to $20,400.

Even if you pay income tax at the lowest 10% rate, this special tax exemption can save you up to $1,020 on your 2020 income taxes, $2,040 for married couples.

However, this tax-free benefit is available only if your household income (adjusted gross income) is under $150,000. The $150,000 ceiling is the same for single and married taxpayers. The IRS says that for these purposes you don't have to include in your household income any of the unemployment compensation you or your spouse were paid in 2020.

If your AGI is $150,001 or more, you fall off the income cliff and must pay tax on all your 2020 unemployment benefits. If your AGI is not much over $150,000, you may be able to reduce it below that level by making contributions to an IRA or health savings account (you can do this until the due date for your 2020 tax return and have it apply for 2020).

The exclusion should be reported separately from your unemployment compensation. The IRS has created an Unemployment Compensation Exclusion Worksheet to figure your exclusion, which you enter on Schedule 1, line 8. Tax software has been updated to apply this exclusion. You just need to answer the applicable questions.

Unfortunately, Congress made this change in the tax law in early 2021 after 55 million taxpayers had already filed their 2020 returns, including many who received unemployment benefits. If you've already filed your 2020 taxes and obtained unemployment in 2020, don't do anything. The IRS says you don't need to amend your tax return. It will automatically refund you the tax paid on these excluded unemployment benefits or apply the amount to other taxes you owe.

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.

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