Unemployment Income and Taxes: Do You Need to Pay?
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If you or another family member who provides household income has been laid off, you probably have applied for unemployment benefits to help supplement lost pay.
The American Rescue Plan, which was enacted on March 11, 2021, includes a new exclusion of up to $10,200 of unemployment compensation. Which means you don't have to pay tax on unemployment compensation of up to $10,200 if your modified adjusted gross income (an individual's total gross income minus specific deductions - this is how your taxable income is calculated) is less than $150,000.
If you are married, each spouse receiving unemployment compensation doesn't have to pay tax on unemployment compensation of up to $10,200. Amounts over $10,200 for each individual are still taxable. If your modified AGI is $150,000 or more, you can't exclude any unemployment compensation.
Unemployment benefits at tax time
People who become unemployed for the first time are often shocked to learn that they must report their unemployment benefits more than $10,200 on their 2020 tax return. You should receive a Form 1099-G showing total unemployment compensation paid to you in 2020. If you move and don't receive a 1099G from your state's unemployment office, you might even forget you received this income altogether. But if you omit unemployment income from your tax return, the IRS will take notice—and expect you to pay what's owed.
It's important to be proactive so you don't get caught short of funds at tax time. When you file for unemployment, consider having federal and state taxes withheld from your benefits. It may be difficult to lose that money from your unemployment check when funds are so tight, but you'll be glad when it comes time to file your taxes in May.
Note: The Internal Revenue Service pushed back the federal income tax filing due date for the 2020 tax year from April 15, 2021, to May 17, 2021. This extended deadline gives you an extra month to file your returns.
If you haven’t been withholding taxes from your unemployment benefits, talk to a tax professional or use your favorite online tax software to project your federal and state tax liabilities. Be sure to include all sources of income, both taxable and tax-free, and any amounts that were withheld from wages, investment accounts and early retirement withdrawals.
Once you know how much you expect to owe the IRS and your state, devise a plan to pay your taxes, either by saving the money or finding a way to borrow it.
Tax consequences of early withdrawal from retirement plans
Sometimes, people who are unemployed will draw money from their retirement plans to help cover expenses while their income is reduced. If you choose to make an early withdrawal, you’ll be required to pay taxes on those funds, and if you’re under age 59 ½, you may also face a 10 percent penalty from the IRS, plus whatever your state charges.
Depending on the type of account from which you are withdrawing money—IRA, 401(k), 403(b) and so on—you may not have to pay a penalty if the money was used for certain common expenditures, including:
- Health insurance while you are unemployed
- Medical expenses above 10 percent of your adjusted gross income
- Qualified higher education expenses
- Payments after the total and permanent disability of the plan participant/IRA owner
Unemployment income can be an invaluable tool to carry you and your family through a tough spot. Just ensure that you’re ready come tax time to avoid unpleasant surprises.