Many Americans found themselves facing unemployment or a significant reduction in work hours in 2020 as a result of the COVID-19 pandemic. Unemployment benefits, including the increased benefits provided by the CARES Act, have provided a much-needed lifeline for many people. However, unemployment benefits are not tax-free. If you collected unemployment benefits in 2020 or 2021, it is important to understand your federal and state tax obligations in order to avoid an unpleasant surprise when you file.
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Will I owe taxes on my state and federal unemployment payments during the COVID-19 pandemic?
Unfortunately, while you may not think of your unemployment benefits as taxable income, the IRS and state tax authorities do view them that way. Both the federally-funded unemployment assistance and state unemployment benefits are taxed by the IRS, as well as by most states. There are a few states that do not tax your benefits at all, while others levy tax on only a portion of your benefits.
Are my unemployment payments taxed at the same rate as regular income?
Your unemployment benefits are taxed at your regular federal income tax rate. However, you do not need to pay Social Security or Medicare tax on unemployment benefits as you would if you were earning paychecks through an employer responsible for deducting your FICA withholdings from each paycheck.
What happens if I didn’t withhold taxes on my unemployment payments?
You have the option of electing whether or not you want 10% of each unemployment payment withheld and applied toward your federal tax obligation. Many people collecting unemployment choose not to withhold taxes, wanting to collect as much as possible. However, this approach can be dangerous.
The “pay as you go” tax system in the U.S. means people are expected to pay income taxes throughout the year. If you opted not to have federal income tax withheld from your unemployment payments, you will not only have to pay those taxes by the April 15 deadline, but you could also face underpayment penalties and interest.
If you opted not to have federal taxes withheld but later change your mind, you can complete IRS Form W-4V to change your withholding election. You could instead lower your risk of underpayment penalties by sending in estimated tax payments to the IRS using either the online payment portal or remitting payment with Form 1040-ES. If your state has an income tax, you may also want to submit estimated tax payments to your state tax authority to avoid underpayment penalties.
If I opted to have federal taxes taken out of my payment, will I still owe any federal taxes on those unemployment payments?
Opting in for the federal tax withholding is a smart way to be proactive about your finances and meet your federal tax obligations. However, withholding is not a guarantee that you will not owe any additional taxes when you file your tax return for the year. If, after factoring in deductions and applicable credits, your tax bill is more than what was withheld, then you’ll need to pay the rest when you file your tax return. If the amount withheld exceeds the amount you owe, you can claim a tax refund.
I may not qualify for certain tax credits because I was collecting unemployment, but can I use my 2019 income to qualify for EITC and child tax credits?
While your unemployment benefits are considered taxable income, they unfortunately are not considered “earned” income for purposes of calculating eligibility for the Earned Income Tax Credit (EITC) and the child tax credit. These credits can be valuable, and many individuals and families count on them to lower their tax bills.
Fortunately, Congress took action in the tax relief bill passed at the end of 2020 to try to help taxpayers qualify for these credits. When you file your 2020 tax return, you can use either your 2020 income or your 2019 income to determine whether you are eligible for one or both of the credits.
Plan ahead and seek guidance from tax and legal professionals
The prospect of significant tax bills from the IRS and your state tax authorities can be stressful. Planning ahead now can help you meet your obligations for 2020 and, if you are receiving unemployment benefits in 2021, can help you adjust withholding elections. Help is available when you need it. Ask a lawyer for simple, trusted, on-demand legal advice today.
This article contains general legal information and does not contain legal advice. Rocket Lawyer is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.