Guest Blogging today from Neal Braver of Brockton, MA:
Believe it or not, unemployment compensation is taxable income. Too few people seem to know this (or want to know this). And this oversight often leaves tax payers owing $1,000 or more in taxes, even when you consider the tax savings from the 2009 Economic Stimulus Package.
And the states-who regulate unemployment-do not always succeed at making sure people understand. On top of this, the way the tax withholding process is structured for unemployment income encourages behaviors that make things worse.
Simply put, you local unemployment office does not automatically start holding out federal and state taxes once you start collecting unemployment. This differs from W-2's where withholding is required from the beginning. Instead, it's left to the individual to contact their state unemployment office and ask them to start withholding 10% for federal taxes and a smaller amount for the state. So box 4 (and whichever box shows state taxes withheld) on the 1099-G starts out as empty. This sends a mixed message and-I contend-encourages people not to withhold, whether accidentally or on purpose.
They Tried To Warn You
Yes, the responsibility for withholding is spelled out in many state documents. But it is assumed that everyone is planning carefully and reads everything they recieve.
And yes, the states have the most noble of intentions to get as much of the money into the hands of the unemployed as possible.
And yes, the government assumes that the adult receiving unemployment will make the best tax decision. But too often tax payers may decide not to withhold taxes without considering the tax impact at the end of the year.
OK, So Let's Do The Numbers
If you do not withhold taxes on unemployment compensation, and you end up collecting for an extended period of time you could easily end up owing taxes. If you collect $7,000-$10,000 or more -which is not that unusual in today's economy-you could end up with taxes on taxable income in the thousands of dollars. Without withholding taxes to cover this debt you will, in all likelihood, owe taxes to Uncle Sam. And you'll probably owe a good chunk of change if your state has income taxes.
With unemployment typcially maxing out at 26 weeks and with some states paying up to $500 per week (even more in some states), an individual could collect as much as $13,000. The taxes owed on this income could be as much as $1,500 in federal taxes. Add state taxes and this debt could climb to as much as $2,000. With an average collection time of 24.5 weeks and average compensation of $300 per week, that's $7,350 income, or taxes owed of about $750 (about $1,000 when you include state income taxes).
This is most painful for a person filing single collecting more than $8,950 (for 2008) in unemployement. At this income level, they will be required to file taxes AND probably will have taxable income.
Add penalties and interest over the year-or-so it takes the IRS to contact you, and you could owe into the thousands. With the federal government extending unemployment compensation, individuals could be pushed even deeper into tax debt. And the government will be remarkably unsympathetic. So far as they are concerned, you are responsible. Ignorance of the law is no excuse!
And They Are Trying To Help
Now, there is a saving grace. Under the new 2009 Economic Stimulus Package, unemployment compensation up to $2,400 is not taxable. This will eliminte most taxes at the low end, and minimize the problem for others by providing a tax savings of around $250-$300. Any compensation exceeding this amount will be taxable. Given the average unemployment paid is about $7,000, taxes on this income will be around $500 for 2009. But in this tough economy, unemployment compensation is going up both in terms of weekly dollars and length of time (right now its at an all time high): Lots of people will be collecting lots more, so the reduction will only moderately lessen the sting.
What They Really Should Do
If I had my druthers, the process would be reversed: Taxes would be held out automatically, with the reciever having the choice of whether to continue to hold out taxes. This-while being politically unpopular-at least prods the individual to consider the tax implications of their decision.
And What You Really Should Do
So contact your state unemployment office-either by phone or online-and have that 10% withheld. You probably don't know how long you'll be collecting (although I hope it will be brief). And if it turns out you don't owe taxes, you'll always get it back as a refund.
Think of the withholding as a safety net for your safety net.
Disclaimer: Every effort has been taken to provide the most accurate and honest analysis of the tax information provided in this blog. Please use your discretion before making any decisions based on the information provided. This blog is not intended to be a substitute for seeking professional tax advice based on your individual needs.