Due to the massive number of job losses caused by the coronavirus pandemic, many Americans are now receiving unemployment benefits for the first time in their lives. Going through a job loss can be incredibly stressful, and taxes aren’t likely to be top of mind as you overcome financial hardship.

However, you are required to pay income tax on unemployment income.

As you handle this stressful financial time, know that there are free tools to help you take control of your overall financial situation.

For now, here’s how to navigate paying taxes on your unemployment compensation.

Unemployment due to Coronavirus

Unemployment compensation must be reported as taxable income during the year in which it is received for federal, and in some cases also state, income tax purposes. This includes special unemployment compensation that was part of the Coronavirus Aid, Relief, and Economic Security (CARES) Act that was passed last year, such as the $600 per week extra unemployment payments that expired at the end of July.

So if you received unemployment benefits at any time in 2020, you must report them on your 2020 federal income tax return. Note, however, that Social Security and Medicare taxes are not assessed on unemployment benefits — only income tax is assessed on the payouts.

Most states also tax unemployment benefits. The exceptions are California, Montana, New Jersey, Oregon, Pennsylvania, and Virginia. Meanwhile, Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming don’t collect any state income tax.

Are you ready to file your 2020 taxes?

Should You Have Taxes Withheld?

To avoid having a big bill on Tax Day, you can choose to have 10% of your unemployment benefits withheld to cover all or part of your tax liability. Simply complete IRS Form W-4V, Voluntary Withholding Request, and send it to the agency that’s paying your benefits. If you prefer, you can make quarterly estimated tax payments instead. 

If you received unemployment benefits in 2020, you’ll receive Form 1099-G, Certain Government Payments, in January from the agency that’s paying your benefits. This form will list how much money you received in unemployment benefits in 2020 along with any federal income tax that was withheld. You’ll then report this information along with your W-2 income (if you had any) on your 2020 federal income tax return.

When Not to Have Taxes Withheld

There’s another factor to consider as you decide whether to have income tax withheld from unemployment benefits. If you worked during most of the year and had income taxes withheld from these wages, you might not need to have more tax withheld from your benefits.

This is because your former employer calculated your income tax withholding as if you would earn the same amount of money for the entire year. However, your income likely went down when you lost your job and started receiving unemployment. 

In this scenario, the money that was withheld from your wages might be enough to cover the income tax that’s due on your unemployment benefits. If you have income tax withheld from your unemployment benefits, this could result in you making extra income tax payments. You’ll eventually receive this money back in the form of a tax refund, but it might be better to keep the money in your own pocket now to help meet your current living expenses.

Next Steps for You

Taxation of unemployment benefits can be complicated. Therefore, be sure to talk to your tax advisor and personal financial planner for guidance in your specific situation.

Difficult financial times happen. You can prepare yourself to bounce back by getting a handle on your finances today.