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 could leave taxpayers owing on their federal and state income tax returns.
The states regulate unemployment, but they do not always succeed in making sure people understand their tax obligations. On top of this, the tax withholding process for unemployment is structured in a way that encourages behaviors that make things worse.
Simply put, your local unemployment office does not automatically withhold 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 you to contact your state unemployment office and ask them to start withholding 10% for federal income taxes and a smaller amount for the state.
They Tried To Warn You
Yes, the responsibility for withholding is spelled out in many state documents. But it is assumed that everyone plans carefully and reads everything they receive.
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 taxpayers may decide not to withhold taxes without considering the tax impact at the end of the year.
OK, So Let's Do The Numbers
With unemployment typically maxing out at 26 weeks and with some states paying up to $500 per week (even more in some states), you 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 under 65 filing single and collecting more than $9,075 (for 2014) in unemployment. At this income level, the individual will be required to file taxes AND may 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.
And What You Really Should Do
So contact your state unemployment office either by phone or online and have that 10% withheld. And if it turns out you don't owe taxes, you'll most likely get it back as a refund.
Think of the withholding as a safety net for your safety net.