Do You Have to Pay Taxes on Unemployment Benefits?

Do You Have to Pay Taxes on Unemployment Benefits? article image.

The American Rescue Plan Act of 2021 changed federal tax requirements on 2020 unemployment benefits. For the latest information, see How Unemployment Benefits Are Changing in 2021.

 

Over 45 million new unemployment claims were filed in the 13 weeks following the declaration of a state of emergency due to COVID-19 in mid-March. For many, especially those filing for benefits for the first time, the fact that unemployment benefits are taxed at the federal, state and potentially even local levels might come as a bit of a shock.

How much you'll pay depends on your overall income for the year and several other factors. When you pay can also depend, as you can either have taxes withheld from your benefit payments like you would a regular paycheck, pay when you file your taxes or pay a quarterly estimated tax.

Which Taxes Apply to Unemployment Benefits?

Generally, you'll have money withheld from your paycheck for several types of taxes: income, Social Security and Medicare.

Combined, the Social Security and Medicare taxes are called Federal Insurance Contributions Act (FICA) taxes, and they can be up to 7.65% of your pay. But FICA taxes don't apply to unemployment benefits.

You have to pay federal income taxes on your unemployment benefits, as well as any applicable local and state income taxes.

Similar to how you receive a W-2 or 1099-MISC tax form with your wages and income and use those to prepare your tax return, your state will send you the IRS copies of Form 1099-G with a record of how much you received in unemployment. You'll include this amount in your income for the year when you file your taxes.

Through July 31, 2020, your taxable unemployment benefits may include an additional $600 a week as part of Coronavirus Aid, Relief and Economic Security (CARES) Act stimulus. The extra benefit also counts as taxable income. The separate one-time stimulus check that was also a component of the CARES Act is not, however, subject to income taxes.

Which States Don't Tax Unemployment Benefits?

Whether you have to pay state income taxes on your unemployment benefits depends on where you live. Some states don't have income taxes or treat unemployment benefits differently from other types of income.

  • Seven states don't have any income taxes: Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming.
  • Two states only have income taxes for investment income: New Hampshire and Tennessee.
  • Six states exempt unemployment benefits from income taxes: Alabama, California, Montana, New Jersey, Pennsylvania and Virginia.
  • Two states may only tax a portion of your unemployment benefits: Indiana and Wisconsin.

In other states, your unemployment benefits may be treated as regular income and taxed at the same income tax rates. Some cities and counties may also have a local income tax that applies to unemployment benefits.

How Much Are Unemployment Benefits Taxed?

At the federal level, unemployment benefits are treated the same as other types of ordinary income. The federal income tax brackets, which range from 10% to 37%, will determine how much you pay.

Which bracket you fall into depends on your total income minus deductions and credits, with the rate you'll pay being determined on a per-dollar basis—you won't pay the same rate for every dollar you made during the year.

It works something like this: If you file as single in 2020, you can automatically receive a $12,400 standard deduction, which reduces your taxable income. As a result, you won't have to pay any federal income taxes on the first $12,400 you make—you might not even have to file a federal tax return. The next $9,875 you make falls into the 10% tax bracket, with the 12% bracket after that covering income from $9,876 to $40,125, and so on (there are five brackets after the 12% bracket).

As the amount you earn climbs, new earnings are pushed into new brackets, but the rate that applies on lower-dollar earnings stays the same. Even if you make $1 million in a year, you still receive the standard deduction, pay 10% on the first $9,875, 12% on the next portion, on up to the top tax rate of 37% for income above $518,400.

As a result, your unemployment benefits may be taxed federally anywhere from 0% to 37%.

How to Prepare for Income Taxes

Knowing that you may have to pay income taxes on your unemployment benefits, you can choose from several options to help make the payments more manageable.

  • Request tax withholdings. When you were working, your company may have withheld money for taxes and made those payments on your behalf. You can also ask your state to do the same with your weekly unemployment benefits. It will withhold 10% of your unemployment pay, which it will send to the IRS. You may also request state or local tax withholdings if they apply to you.
  • Pay estimated taxes. Another option is to make estimated tax payments to the IRS and your state tax agency every quarter. Depending on how much unemployment you collect, and what other sources of income you have throughout the year, you may want to do this even if you have money withheld from your benefits. If you wind up owing more than $1,000 in income taxes, you may have to pay an additional underpayment penalty.
  • Set money aside. You could choose to keep all your unemployment benefits if you don't expect to owe any taxes. Or, even if you expect to owe a little, you could still keep the money and set a portion aside in a savings account in case there's an emergency in the interim. An income tax calculator could help you estimate how much you'll want to set aside.

If you pay too much in taxes now, you'll get the overpayment back when you file your tax return later. Even if you aren't required to file a return next year, you should file one if you had any money withheld from paychecks or unemployment benefits so you can get that money refunded.

Protecting Your Credit When You're Unemployed

While unemployment benefits can help you cover basic necessities, they won't necessarily be enough to cover all your bills. While being unemployed doesn't impact your credit directly, it can indirectly hurt your credit if you fall behind on bills.

Many creditors recognize that you could be unemployed because of circumstances outside your control, and may work with you to temporarily waive or lower your payments. These hardship options can make it easier to manage your bills, and working with the company rather than skipping a payment without an explanation can help protect your credit.

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