Extended unemployment benefits provided much-needed relief to 40 million people in 2020, according to Century Foundation statistics. But now millions of Americans are facing surprise tax bills that are higher than expected.
Many Americans didn’t realize that unemployment benefits are taxable by the federal government and also by some states. Many also didn’t know there are ways to defray your tax liability by having your state unemployment office or the federal government withhold taxes on your unemployment payments. And to complicate matters further, some states failed to withhold portions of federal unemployment payments issued as part of the Federal Pandemic Unemployment Compensation or the Lost Wages Assistance program, CNBC reported.
However, Senate Democrats Friday afternoon proposed a tax waiver on up to $10,200 of unemployment insurance benefits. Researchers estimated that only 40% of 2020 unemployment payments had taxes withheld, CNBC reported. And although states were supposed to be withholding payments, many did not.
People who received unemployment in 2020 will receive a Form 1099-G, Certain Government Benefits, that shows the amount received during the year, according to the IRS. You’ll need to report this amount on your Form 1040 when you file your taxes this year. Because of the added benefits as part of coronavirus relief, your unemployment income could change your tax bracket from what you expected, so review your tax paperwork carefully to determine what percentage of your adjusted gross income you’ll need to pay.
It’s important to note that both state unemployment insurance and additional unemployment compensation through the CARES Act, as well as the FPUA and LWA, are all taxed, CNBC wrote.
However, many Americans who opted to have 10 % of their state unemployment benefits withheld did not have the choice to have a portion of their federal enhanced benefits withheld, according to CNBC. A woman in Minnesota, who asked to have her name withheld, discovered when she received her tax bill that the withholding only applied to standard state unemployment.
Similar issues cropped up in California and other states, according to CNBC. “This withholding option was not available for the $600 pandemic additional compensation payments, which needed to be quickly implemented at the time to get benefit funding to eligible claimants in need of them,” Loree Levy, deputy director of public affairs for California’s Employment Development Department, told CNBC.
In addition to owing taxes on unemployment, you could owe the IRS a “Penalty for Underpayment of Estimated Tax” if you haven’t paid most of your taxes owed for the year before April 15. The IRS says this penalty will be waived if you:
- Owe less than $1,000 after subtracting withholding and deductible credits
- Paid 90% of the current year’s taxes by April 15 or
- Paid an amount equal to 100% of the prior year’s taxes by the deadline
You Can Adjust Withholding or Make Quarterly Payments Now for the 2021 Tax Year
The IRS writes that any Americans receiving state or federal unemployment benefits, including those paid from the Federal Unemployment Trust Fund, can opt to have 10% of those payments withheld. The same way employers withhold payroll taxes before you receive your paycheck, the agency paying your unemployment can also withhold taxes. You can file Form W-4V, Voluntary Withholding Request with the agency — not with the IRS. “If the payor has its own withholding request form, use it instead,” says the IRS website.
if you are receiving enhanced unemployment benefits as part of the new COVID-19 stimulus package, it’s important to inquire if the state will be withholding taxes on federal payments as well.
If you don’t want 10% of your benefits withheld or you’re concerned that money won’t be withheld for federal payments, you can make quarterly estimated tax payments to the IRS. Quarterly payments for 2021 are due on April 15, July 15 and Sept. 15 of this year, and then on Jan. 17, 2022 (because the 15th falls on a Saturday).
Ways to Reduce the Taxes You Owe This Year
If you’re facing an unexpected tax bill this April and are a parent or legal guardian, don’t panic. You may qualify for an earned income tax credit worth up $3,000 per child for children ages 6 to 16 and $3,600 for children under age 6, CNET reports. These credits, part of the proposed American Rescue Act, can help reduce your tax bill. Additionally, the new legislation calls for a refundable child-care tax credit of up to $4,000 for one child or $8,000 for two or more children.
Normally, you wouldn’t be able to use the earned income credit to reduce taxable unemployment insurance, since unemployment benefits are not considered earned income by the IRS. But this year, as part of the Taxpayer Certainty and Disaster Tax Relief Act of 2020, you can use your earned income amount from 2019 to calculate your EITC for 2020, according to the IRS. If you were employed, running a business or working as a 1099 contractor in 2019 but filed for unemployment in 2020, your earned income from 2019 may help reduce your 2020 tax bill through the EITC.
Holding Out Hope
If the latest version of the $1.9 trillion COVID-19 relief package passes Senate, up to $10,200 in taxes for unemployment benefits could be waived.
The new version of the bill also calls for enhanced unemployment benefits to run through early October at a reduced rate of $300 per week instead of $400.
Consult a Tax Professional
Since tax returns may be more complicated this year, consider speaking to a tax professional who understands the tax law and can review all your deductible expenses to help reduce your tax liability.
If your employment situation changed dramatically during the pandemic, consider filing your taxes as early as possible so you can be prepared for the possibility of a bill. No matter when you file, your taxes aren’t due until April 15. Filing early will help you get a clear picture of your finances and figure out how you might pay the taxes owed to avoid penalties.
If you determine you can’t come up with the money, the IRS may be able to grant you a short-term extension, an installment agreement or an offer-in-compromise. You can negotiate these terms yourself by calling the IRS at 800-829-1040 or enlisting the help of a tax professional to help you through the process.
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