Believe it or not, unemployment compensation is taxable income. Too few people seem to know this — or maybe it’s just that too few people want to know this. Nevertheless, this oversight could lead to taxpayers who didn’t withhold taxes from unemployment benefits owing on their federal and state income tax returns.
The states regulate unemployment benefits, but not all recipients understand their related tax responsibilities. They must actively undertake the process to withhold taxes from unemployment benefits; taxes aren’t automatically deducted.
Simply put, your local unemployment office does not automatically withhold federal and state taxes once you start collecting unemployment. This differs from W-2s, where employers are required to withhold these taxes from your paycheck up-front. Instead, it's left up to you to contact your state unemployment office and ask them to withhold 10 percent for federal income taxes and any applicable state income taxes as well.
They Tried to Warn You
Yes, many state documents spell out that the responsibility for withholding is on the taxpayer. However, not everyone carefully reads everything they receive.
It’s assumed that the adults receiving unemployment will make the best tax decision for themselves. Too often, however, taxpayers choose not to withhold taxes from unemployment and don’t consider what that will mean 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 — although many states offer higher weekly benefits or income for longer durations — you can collect as much as $13,000. The taxes owed on this income could be as much as $1,500 in federal taxes. Add in 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. This puts estimated taxes owed at about $750, or around $1,000 when you include state income taxes.
This is most painful for a person under 65, filing as single, and collecting more than $10,350 in unemployment. At this income level, the individual will be required to file taxes AND may also have made enough to 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 of dollars.
What You Should Do
Instead of worrying about how much you have to pay at the end of the year, contact your state unemployment office, either by phone or online. Have them withhold the 10 percent required for federal taxes and whatever percentage is required for state income taxes in your state. If it turns out you don't owe taxes, you may get it back as a refund. Better to have taxes taken out initially than to worry about how to pay a significant debt at the end of the year.
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