We get it — it’s hard to think about future stuff when you’re busy trying to hold it together one day at a time. If you’re facing unemployment, it can feel like you don’t even have today under control, let alone tomorrow. During this difficult time, your unemployment benefits are an absolute blessing, and we want to help you make sure they stay that way.

Planning ahead can feel overwhelming, but the blessing of unemployment can become a curse on April 15 if you’re not prepared for the tax consequences of your unemployment payments. If you’re receiving unemployment compensation, it’s important to understand if and how it will impact your taxes. We’re happy to explain it all to you in plain English so you know what you need to do.

Is Unemployment Taxable?

In short, yes. The taxing of unemployment money comes down to one basic question: Does unemployment count as income? Again, the short answer is yes.

Here is the basic reasoning. The IRS taxes your earned income. Unemployment assistance essentially replaces that income, and so the IRS taxes it in the same way. Your state and local taxing authority may do the same, but we’ll explain that in more detail in a minute.

How Unemployment Changed with COVID-19

corona virus

COVID-19 changed the way we do almost everything, and unemployment is no exception. Because so many people found themselves furloughed or let go during the pandemic, Congress made some helpful changes to the unemployment system.

Perhaps the most well-known change was that the federal government provided an extra $600 per week to unemployment recipients, which was quite helpful. The amount of time that a person can collect unemployment was also extended, in most cases from 26 weeks to 39. Benefit waiting periods were also waived, allowing unemployed persons to begin receiving their benefits more quickly.

Congress even extended the eligibility criteria, offering unemployment benefits to the self-employed and those working as independent contractors. These people ordinarily aren’t eligible for unemployment.

All of these changes proved beneficial, allowing more people to collect unemployment, letting them do so for a longer period of time and getting more money than usual into the hands of those who needed help. Unfortunately, Congress didn’t provide any type of tax relief to offset this increase in unemployment compensation.

What Taxes Come Out of Unemployment?

The IRS taxes your unemployment in a very similar way as it does your regular income, but it’s not exactly the same. This is actually good news! While you will have to pay federal income tax on your unemployment money, you won’t have to pay social security or Medicare tax. That’s a savings of 7.65 percent, which can be significant. 

You may not have to pay state income tax on the money, either, depending on where you live. Again, we’ll explain soon.

Which States Don’t Tax Unemployment Benefits?

states with no income tax

The moment has finally arrived! We’ve been promising to explain how the states handle unemployment taxation, and now is the time. There are seven states that don’t have an income tax at all. In these states, your unemployment is not taxable. They are:

  • Alaska
  • Florida
  • Nevada
  • South Dakota
  • Texas
  • Washington
  • Wyoming

New Hampshire and Tennessee tax investment income but not earned income. In these states, your unemployment compensation is not taxable.

There are six states that do tax income but waive this tax for unemployment payments. This means that you won’t pay state tax on your unemployment if you live in these states:

  • Alabama
  • California
  • Montana
  • New Jersey
  • Pennsylvania
  • Virginia

If you live in any state we haven’t mentioned, your unemployment is taxable in your state. Indiana and Wisconsin may only tax part of your unemployment, but you should still be prepared to pay something when you file your tax return.

Local taxing authorities are far too numerous to pin down. According to the Tax Foundation, more than 4,964 local jurisdictions collected income tax in 2019. With that many taxing authorities in play, we can’t possibly tell you what your local unemployment taxation rules may be. The safest bet is to call your local tax office and ask them if they tax unemployment assistance.

How to Pay Taxes if You’re on Unemployment

When you receive unemployment, there are two basic ways you can handle your tax liability. One is through withholding. Many states ask if you would like to have federal and applicable state taxes withheld from your unemployment checks when you first file for benefits. 

If that ship has already sailed, it’s not too late. You can ask the federal government to withhold taxes from your unemployment check for you using a Form W-4V. States that tex unemployment usually have a similar form that you can file to request that your state taxes are withheld too. 

This withholding works just like the withholding on your regular paycheck. If it turns out you overpaid at the end of the year, you’ll still be entitled to a tax refund.

The second option you have for paying your taxes is to withhold them yourself. Self-employed people do this all the time, and you can too. Simply choose a percentage of each unemployment payment, say 10 or 12 percent, and set it aside in a savings account so you have it at the end of the year. 

If you’re saving your taxes on your own, remember that you may not have the option of waiting until the end of the year to pay. The federal tax is technically a pay-as-you-go tax. If you owe a little at the end of the year, you can simply pay the tax when you file your tax return. If you expect to owe a lot, however, both the IRS and state governments expect you to make estimated tax payments.

Tax Deductions and Credits for the Unemployed

tax deductions for unemployed

You may have to pay tax on your unemployment, but you’re still allowed to take advantage of deductions and credits that lower your tax liability. Remember to check and see if you qualify for the earned income tax credit (EIC). You may be eligible this year even if you haven’t been in the past. (Unemployment money may get taxed as income, but it doesn’t classify as “earned” money for the EIC, a distinction that could benefit you greatly.)

Child tax credits can also reduce your tax liability, as can the child and dependent care tax credit. If you can afford it, contributing to your IRA will also reduce your taxable income, and thereby your tax liability. This can understandably feel tricky during periods of unemployment, but if you can pull it off, it will help you a tax time and again at retirement time. Don’t let a temporary setback disrupt your bigger long-term retirement plans if you can avoid it.

Hopefully, you now have a better understanding of how unemployment assistance impacts your tax picture. But as those who’ve previously worked with us already know, we’ll never leave you hanging. If you have any questions about your unemployment taxes, making estimated tax payments or anything else, Picnic Tax is always here to help. Meet a few of Picnic’s online accountants. We’ll be happy to tell you more about what we do and how we can help.