If you got unemployment benefits in 2020, you just got a tax break courtesy of the $1.9 trillion American Relief Plan that President Joe Biden signed into law on Friday. Here’s how the latest relief bill could affect your taxes.
How the Relief Bill Affects Your Taxes if You’re Unemployed
Let’s back up: Is unemployment taxable? Unfortunately, the answer is yes — and that can seem like Uncle Sam kicking you when you’re already down.
The American Relief Plan provides a small measure of relief: The first $10,200 of unemployment compensation will be shielded from taxes for households with incomes under $150,000 in 2020.
The IRS hasn’t yet issued guidance for people who received benefits in 2020 but have already filed a tax return. It’s likely in this situation that you’d need to file an amended tax return to adjust what you owe.
Note that this exemption only applies to 2020 taxes. If you’re still receiving unemployment, you should still expect to pay taxes on the full amount when you file your 2021 return next year.
How Are Unemployment Benefits Taxed?
Many people are surprised to learn that they have to pay taxes on their jobless benefits. A Jackson Hewitt survey found that 39% of adults weren’t aware that unemployment is taxable. Here’s a breakdown of how taxes on unemployment benefits work.
Federal Income Taxes
When you receive unemployment benefits, they’re taxed at the federal level as ordinary income.
That means if you got $15,000 from unemployment during a typical year, it would be taxed in the same income tax brackets as it would if you’d earned $15,000 from a job. But you wouldn’t owe payroll taxes, i.e., Social Security and Medicare taxes, on your benefits.
Because the new relief bill exempts the first $10,200 from taxes, you’d only be taxed on $4,800 if you received that same $15,000 of unemployment benefits in 2020.
Unemployment compensation can affect your tax bill in other ways. As many as two-thirds of people who got the $600 weekly CARES Act supplements that ended in July were making more money than they were from working. If your 2020 income was higher than it normally is because of your jobless benefits, you may find that you’re no longer eligible for some tax credits, like the earned income tax credit.
State Income Taxes
At the state level, it looks a little different. If your state is one of the nine that doesn’t have an income tax, it’s easy: You won’t owe state taxes on your unemployment. Of the remaining 41 states, the following five exempt unemployment from taxes:
- New Jersey
A few others partially tax unemployment, but in most states, your unemployment is fully taxable.
How Do I Pay Taxes on My Unemployment?
There are two basic ways to pay federal taxes on your unemployment. Because the U.S. has a pay-as-you-go tax system, neither answer is “pay it all next year” — though as we’ll discuss shortly, the consequences for doing so aren’t too harsh.
This is how it works when you’re employed and your employer automatically takes out a portion of your check for taxes. You can opt to have 10% of your benefits automatically withheld, but you don’t get the choice of having more or less withheld.
When you first apply for benefits, you’ll have the option of filling out IRS Form W-4V for voluntary withholding. If you’re already receiving benefits, you can still submit Form W-4V to your state office to change your withholding.
Estimated Quarterly Payments
The IRS says you should make quarterly estimated payments if you expect to owe at least $1,000 in taxes from all your income sources and you haven’t had at least 90% of what you’ll owe for the year withheld. Alternatively, you’re in the clear if you had 100% of the prior year’s tax bill withheld if your adjusted gross income is under $150,000, or 110% if your AGI is over $150,000.
What if I Haven’t Had Taxes Withheld?
There’s no need to panic if you haven’t had taxes withheld on your unemployment compensation.
A lot of people are in that situation. Either they haven’t had taxes withheld because they’ve needed their entire check to survive, or they just didn’t know they had to pay taxes on their benefits.
If you’re still receiving benefits and the 10% withholding wouldn’t threaten your ability to pay for your basic needs, we suggest submitting Form W4-V to your state unemployment office ASAP.
The worst-case scenario: You owe money on April 15 and can’t afford the bill.
While the IRS may have a reputation for making grownups cry, owing money at tax time isn’t as terrifying as it sounds, so long as you file a tax return on time. (You can get more time to submit your return if you file for an extension, but the tax bill is still due on April 15.)
In most situations, you can automatically get approved for a payment plan that will cost you just 0.5% in interest per month, up to 25% of your overall bill. If you can afford to pay the entire bill within 120 days, you won’t incur additional fees. Otherwise, you’ll pay $31 to set up a direct deposit payment plan online or $107 to set it up by phone or email, or in person.
Of course, the IRS will encourage you to pay as much as you can afford, but you can select a monthly payment that’s as low as the total amount you owe divided by 72.
Fees aside, 0.5% per month works out to 6% per year. By comparison, the average credit card interest rate is over 17%, which makes the IRS look like a pretty generous creditor. For that reason, we’d suggest going with a payment plan when you can’t afford a tax bill, rather than charging it to a credit card.
You may also qualify for certain tax credits that will offset the amount you owe.
Just make sure you file a tax return next year, even if you can’t afford to pay. The failure to file penalty is pretty steep at 5% per month up to 25% of your tax bill.
The bottom line: You will pay taxes on your unemployment compensation. Pay them upfront either automatically or quarterly if you can. But know that if you owe taxes on your benefits next year, that doesn’t spell doomsday for your finances.
Robin Hartill is a certified financial planner and a senior writer at The Penny Hoarder. She writes the Dear Penny personal finance advice column. Send your tricky money questions to [email protected]