The Department of Labor reported a staggering 75.9 million initial unemployment insurance benefits claims from January 5, 2020 to January 2, 2021. The number of weekly claims spiked in March, underscoring the devastating financial impact of the COVID-19 pandemic and creating millions of first-time unemployment recipients who might not realize that those benefits are taxable.
Tax professionals are uniquely positioned to help their current and prospective clients avoid a surprise tax bill from their unemployment benefits. After all, losing a job can be a traumatic—often sudden—experience, and learning the ins and outs of unemployment tax liability while frantically trying to make ends meet can be an uphill struggle.
Why are unemployment insurance benefits taxable?
Unemployment insurance benefits are considered taxable income. “By law, unemployment compensation is taxable and must be reported on a 2020 federal income tax return,” the IRS explains. “Taxable benefits include any of the special unemployment compensation authorized under the Coronavirus Aid, Relief, and Economic Security (CARES) Act, enacted this spring.”
While many taxpayers may not realize unemployment payments are taxable, it might also come as a shock that withholding is not automatically taken from those benefits. As with other taxable income, recipients have two options for handling their unemployment tax bill:
- Choosing to withhold tax from each unemployment payment
- Making quarterly estimated tax payments
The IRS says that taxpayers who want to choose withholding need to “fill out Form W-4V, Voluntary Withholding Request, and give it to the agency paying the benefits” instead of the IRS. Further, “if the payor has its own withholding request form, use it instead.” The agency lists the following types of payments as eligible for withholding:
- Benefits paid by a state or the District of Columbia from the Federal Unemployment Trust Fund
- Railroad unemployment compensation benefits
- Disability benefits paid as a substitute for unemployment compensation
- Trade readjustment allowances under the Trade Act of 1974
- Unemployment assistance under the Disaster Relief and Emergency Assistance Act of 1974, and
- Unemployment assistance under the Airline Deregulation Act of 1978 Program
Depending on taxpayers’ individual circumstances, withholding might not be enough to satisfy their tax liability. Quarterly estimated payments can make up the difference, but those who have only ever had taxes withheld from their paychecks may not understand the process. That’s when Form 1040-ES, Publication 505, and a qualified tax professional come in handy.
How do taxpayers determine the amount they should withhold from each unemployment payment?
The IRS recommends checking the IRS Tax Withholding Estimator on IRS.gov to help calculate withholding—especially when unemployment recipients return to work.
Taxpayers who received unemployment in 2020 need to check their mailbox
Whatever agency is actually responsible for paying a taxpayer’s unemployment compensation in 2020 will send Form 1099-G, Certain Government Payments, this month. The IRS says the form “[shows] the amount of unemployment compensation they received during 2020 in Box 1, and any federal income tax withheld in Box 4.”
Where can taxpayers find more information about unemployment benefits?
Taxpayers looking for additional unemployment information not included in the above-listed forms and publications should check the “Unemployment Benefits” section of Publication 525, Taxable and Nontaxable Income.
The good news is that vaccine distribution has already begun. Unfortunately, some estimates predict masks, social distancing, and possible lockdowns could be required until the fall or winter—meaning more taxpayers may need to take advantage of unemployment insurance benefits until we’re on the other side of the pandemic.
Sources: IR-2020-185; Department of Labor, “Seasonally Adjusted US Weekly UI Claims (in thousands),” Jan. 21, 2021
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