The COVID-19 pandemic left millions of people unemployed in early 2020. Although some people have managed to return to their jobs, many still depend on unemployment insurance for financial support.
With the tax season set to start in mid-February, many people who received unemployment checks in 2020 are about to have an unpleasant surprise. When preparing your 2020 federal tax returns, you will have to report these unemployment benefits as income to the IRS and probably pay taxes on them.
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How unemployment checks are treated for federal taxes
The federal definition of gross income includes the money you receive as unemployment insurance benefits. The general idea is that if you were working, the money you would receive as a salary or salary would be taxed. Therefore, the money you receive instead of working should be treated in the same way.
The IRS will collect unemployment benefit taxes, regardless of whether they are federal or state unemployment insurance funds. More support from special unemployment programs is also usually included.
The only exception is if your employer has created a private fund to which you must make contributions with your own salary. In that case, you do not have to pay taxes, assuming that what you receive is less than what you paid to the fund. If your benefits exceed your contributions, however, you are at risk at the time of excess tax.
A drop in payroll taxes
Given the IRS ‘position on how unemployment benefits are similar to wage income, you might reasonably think that the tax agency would beat you for payroll taxes to support Medicare and Social Security as well. However, these wage taxes do not apply to unemployment checks.
Typically, you will not have an extra 7.65% taken out of your federal or state unemployment benefits. If your company offers its own private supplementary unemployment insurance fund, these benefits can be withheld at source. In that case, consult your employer’s HR department for more information.
Giving a double blow
If your state charges your own income tax, you will probably have another tax account to pay on your unemployment checks. Only a few states, including Alabama, California, Montana, New Jersey, Pennsylvania and Virginia, have special provisions that make unemployment benefits exempt from state income tax.
In addition, even if you are taxed as if the money you are receiving is income, you cannot treat it as income from work for tax purposes. The biggest problem with this is that unemployment benefits do not count in determining how much you will receive from the federal income tax credit. For many struggling middle and low income taxpayers, earned income tax credit provides thousands of dollars in tax breaks. However, even at a time when you need this help most, unemployment insurance does not offer additional credits.
Be ready
Dealing with taxes when you are out of work may seem unfair, but it is important to be prepared.
You can usually have money withheld from your unemployment check to go to taxes. That way, the money you owe will never be in your hands. Alternatively, you may need to make estimated tax payments on a quarterly basis to avoid penalties.
It may seem crazy to have money withdrawn from your checks when you need every dollar you can get. Still, knowing the rules helps to avoid the much bigger problem of a huge and unexpected tax bill in April.