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Unemployment Income and Taxes: Do You Need to Pay?

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If you or another family member who provides household income has recently been laid off, you probably have already applied for unemployment benefits to help supplement lost pay. But did you know that unemployment income is subject to both federal and state taxes? Although not every state taxes unemployment income, the vast majority do. Check with your state to determine whether you or a family member will be responsible for recording unemployment income when you file state taxes.

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 on their tax return. 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 April.

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.

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