Collecting unemployment? How to avoid a tax bill next year
With more than one in 10 workers currently jobless, many Americans are depending on unemployment benefits as a financial crutch to get them through the pandemic. The $2 trillion Coronavirus Aid, Relief and Economic Security (CARES) Act dramatically expanded unemployment benefits by amount, how long they last and who is eligible.
While unemployment benefits are undoubtedly a lifeline for many right now, they could be a cause for headaches come next tax season. Unemployment benefits are considered taxable income, but there’s action Americans need to take to make sure that tax makes its way to Uncle Sam.
Unemployment Income Isn’t Automatically Taxed
Unemployment benefits are considered taxable income by the Internal Revenue Service (IRS). However, that doesn’t mean taxes are automatically taken out on unemployment payments like a regular paycheck. You’re responsible for accounting for the taxes on these benefits—or else you could face a big tax bill next April.
Like other forms of compensation, unemployment benefits are subject to federal taxes. But state taxes on the benefits will vary depending on which state the recipient lives. For example, states like Alabama, California, Montana, New Jersey, Virginia and Pennsylvania don’t include jobless benefits as taxable income.
The nine states without a broad income tax also don’t tax jobless benefits. Those states are Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming.
There is no requirement to have taxes withheld from unemployment checks, but doing so could prevent a large tax bill next year.
How to prepare now to avoid a tax hit later
While applying for unemployment benefits, it’s important you take note of the forms you’re filling out. Some states incorporate federal and state withholding during the sign-up period.
While enrolling in jobless benefits, you might be asked to fill out a Form W-4V. This IRS form allows individuals to request a flat 10% be withheld from their unemployment compensation.
Michele Cagan, a CPA in Baltimore, cautions that this 10% tax rate might not be enough for everyone.
“It depends how much you worked during the year, what other income streams you might have. Some people get unemployment and have side gigs or their spouse is working,” Cagan says. “It really depends on your personal situation.”
Cagan advises individuals to visit the IRS website’s withholding estimator to check if they are on track with how much taxes they’re paying throughout the year. The estimator asks for information from recent pay statements and other sources of income, as well as a most recent tax return.
After using the withholding estimator, you might find that 10% withholding on your unemployment checks isn’t enough to cover your tax liability. If that’s the case, or if you don’t opt into the 10% federal withholding, making estimated quarterly payments can help manage a tax liability throughout the year, rather than having a giant tax bill in April.
You can pay your quarterly income tax payments every three months, with caveat: You’ll have to calculate your estimated payments on your own. IRS From 1040-ES is a worksheet that walks you through the calculation to determine your estimated taxes.
Paying estimated quarterly taxes won’t be a viable option for everyone, though. Some taxpayers might be on such tight budgets while receiving jobless benefits that saving enough to pay estimated quarterly taxes is out of the question.
Failing to pay estimated quarterly taxes doesn’t mean you’ll be off the hook, though. There is a penalty for underpayment of estimated taxes (though you can request it be waived in certain instances with Form 2210), but Cagan says it comes down to prioritizing needs, especially during the coronavirus crisis.
“If you find out that you can’t pay your estimated tax and pay your rent, then don’t pay the quarterly estimate; pay your rent instead,” Cagan says. “The tax and penalty that you eventually might maybe have when you pay your taxes in April 2021 will be nothing compared to not paying your rent or having food to eat right now. Right now, cash is cash.”
What about the $600 weekly unemployment benefits boost?
One provision in the CARES Act, however, has caused some difficulty for states trying to implement it into their unemployment benefits programs.
Pandemic Emergency Unemployment Compensation (PEUC), provided by the CARES Act, granted unemployed Americans a weekly $600 boost on top of their state benefits. This boost is a supplement to state unemployment benefits and was intended to fully replace median wages as millions of Americans suddenly found themselves out of work.
When it comes to taxes, however, PEUC should be given extra consideration. Since PEUC provides more money to individuals, that’s more money that can be taxed—and more money individuals could owe to the government next year.
Many states will give individuals the option to have taxes taken out of the jobless benefits while they’re signing up through the unemployment website. However, there have been reports of some states being unable to withhold federal taxes from PEUC.
New Jersey, for example, claimed it didn’t give individuals the option to withhold federal taxes from the additional $600 per week because doing so would have delayed distribution of the money. (That doesn’t mean it isn’t taxable however. New Jersey, like other states, is required to send a 1099-G form reporting all the unemployment you received to both you and the IRS after 2020.)
Individuals should check with their unemployment benefits statements to determine if their PEUC has been taxed; this can usually be done online through the state’s unemployment portal. If not, they will have to prepare accordingly.
How the Earned Income Tax Credit (EITC) could help
If you’re worried you might face a large tax bill in April 2021, see if the Earned Income Tax Credit (EITC) can help offset those costs. This credit is for people with low to moderate income and reduces the amount of tax you may owe. The credit is refundable, meaning if it makes your tax bill less than zero, you could receive a refund from the government.
The EITC can provide between $538 and $6,660 in tax credits, depending on earned income amounts and number of dependents.
The 2020 income limit for EITC is $15,820 for single filers and $21,710 for married couples filing jointly, according to the IRS. Those thresholds sound low, but increase dramatically if you have qualifying children.
These income limits are based on total income, which means you’ll need to include unemployment benefits in the calculation for eligibility. However, a separate eligibility test requires you to have actual earned income that does not include unemployment benefits.
If that sounds confusing, it is. Fortunately, the IRS has an EITC Assistant to help you estimate whether you’ll be eligible for this important tax benefit for 2020. In many cases, any numbers you plug in at this point are just a guess, since you don’t know when you’ll get a new job, how much it will pay, or how much in unemployment benefits you’ll end up receiving.
“Definitely not enough people take the EITC to begin with, and that’s because they don’t even know that they qualify,” Cagan says. “It’s still worth looking into.”