Here's what you need to know about paying taxes on unemployment benefits

Korrawin Khanta / EyeEm

Millions of Americans have filed for unemployment over the past year as the coronavirus pandemic hit the U.S. and prompted many businesses to hit pause. 

But thanks to federal lawmakers, more out-of-work Americans can apply for unemployment benefits and also get more in their pocket under new, temporary rules put in place. 

While that's good news for many struggling amid the pandemic, it's important to understand that unemployment benefits are not "free money." In fact, experts say Americans receiving these weekly checks need to take steps now to avoid a nasty surprise on their tax bills next year. 

How the unemployment landscape changed

With the U.S. experiencing unemployment rates last year that have not been seen since the Great Depression, Congress had to act quickly to mitigate the effects. To help Americans cope, lawmakers passed the CARES Act, a $2 trillion coronavirus relief package, that boosted unemployment benefits by $600 a week.

The CARES Act also created the Pandemic Unemployment Assistance (PUA) program, which expanded the eligibility for benefits to include gig workers, independent contractors, self-employed Americans and those who would not traditionally qualify for assistance. 

After the initial $600 enhanced unemployment benefits ended in July, an additional $300 boost was granted in August and later extended by lawmakers in December. The $900 billion relief package passed in December extended the program through March 14, as well as the Pandemic Emergency Unemployment Compensation and PUA programs, both of which were set to expire at the end of 2020.

Unemployment benefits replaced about 45% of a worker's pay nationally in 2019, according the Department of Labor. In terms of dollars, the Brookings Institution estimates that the national average weekly payment was $387 prior to the coronavirus pandemic. But that varies widely by state. Mississippi, for example, paid an average of $215 per week, while those in Massachusetts received $550 per week, on average. 

Under the new rules, unemployed Americans are now getting a higher average weekly unemployment benefit. But that money is considered taxable income, including both the $600 and $300 enhanced benefits. While you don't have to pay Social Security or Medicare taxes — typically about a combined 7.65% rate — while receiving unemployment benefits, you do have to pay federal income taxes and state taxes in some jurisdictions. 

Some states, however, waive income taxes on unemployment checks. If you live in a state like California, Montana, New Jersey, Pennsylvania and Virginia, your unemployment benefits are tax-exempt. Additionally, seven states —Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming — do not levy any state income taxes

Why withholding makes sense—and how to do it

You're not required to have taxes withheld from your unemployment benefits check. But experts say it's a good idea to go ahead and do so. Taking a hit upfront is better than finding out you owe the IRS at the end of the year. "I know people really need their money, but so there are no surprises at tax time, I would say request to withhold some of the money," says Lisa Greene-Lewis, a certified public accountant and TurboTax tax expert.

This is especially important if you've earned income already for the year or expect to be employed again, because then you're likely to be in a higher tax bracket and may not qualify for as many credits to offset your earnings.

"Usually unemployment benefits are only a couple hundred bucks a week," says Andrew Stettner, a senior fellow at the Century Foundation and a leading unemployment expert. It might feel easy to rationalize taking the money now and increasing your deductions when you get back to work. But with these generous unemployment benefits, that mindset could be a substantial liability, he says. 

Here's how unemployment benefits are calculated on a $40,000 salary
Here's how unemployment benefits are calculated on a $40,000 salary

To request the withholding, you need to fill out form W-4V (the "V" stands for voluntary). Depending on your state, this may be something you can do online through the benefits portal. A flat federal tax rate of 10% of the benefits paid can be withheld from each payment, according to the Labor Department

For those already collecting unemployment, Greene-Lewis says you should be able to request a form W-4V through each state's unemployment office and change your withholding or stop it at any time.

Another option is to do it yourself, says Stettner, similar to how freelancers should save part of their paychecks to put toward taxes. "Put it in a savings account or take the money out [of your checking account] and put it in a little envelope, whatever you need to do to save that money," he says. 

If you don't withhold upfront, you'll likely need to send quarterly estimated tax payments to the IRS to avoid a big tax bill next spring. TurboTax has a W-4 withholding calculator that may be useful in helping you calculate your estimated payment, or you can opt to work with an accountant. 

If you are unemployed at the moment and worried about how this will impact your taxes, Greene-Lewis says that the earned income tax credit (EITC) might be something worth looking into. The EITC provides between $538 and $6,660 in tax credits, depending on your income and the number of dependents you have. If you qualify, the tax credit can be used to offset what you owe on your total tax bill.

Let's say you owe $1,000 on your federal income taxes for 2020, but your earned income tax credit amounts to $1,500. You'll actually get a refund of $500. 

The 2020 income limit for the EITC is $15,820 for those without children who are single and $21,710 for married households filing jointly. In the past, you may have made too much to qualify, but those who are on unemployment for several months may qualify since the IRS doesn't consider unemployment checks earned income.

Keep in mind that tax credits are not something you should bank on to wipe out what you owe to the IRS. "I wouldn't count necessarily on the tax credits for your tax liability," Stettner says. 

This article has been updated to include additional information on unemployment changes, including the extension of $300 enhanced benefits in December 2020.

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How unemployment benefits are calculated
How unemployment benefits are calculated