Many people may be surprised to learn that unemployment compensation is treated as taxable income by the Internal Revenue Service (IRS), just as if it were wages.
When unemployment compensation was first introduced, it was tax free. Many people felt, and still feel, that for the government to take back a portion of what they pay in benefits doesn’t make a lot of sense.
However, other people believed that the amount of unemployment compensation was generous enough to provide a disincentive for recipients to really try all that hard to find employment, so to take a bite out of the benefits, Congress made them partly taxable in 1979. In 1987, they were made fully taxable.
Congress did provide some relief from the tax recently, but for one year only, through the February 2009 “American Recovery and Reinvestment Act of 2009” (the so-called “stimulus bill”). For the 2009 tax year, the first $2,400 of unemployment compensation is excluded from the tax. For a couple filing jointly, each may exempt up to $2,400, for a maximum total of $4,800.
If you receive unemployment compensation, you should receive a Form 1099-G showing the total amount you received for the year. This is reported (minus $2,400 for 2009) on line 19 of Form 1040, line 13 of Form 1040A, or line 3 of Form 1040EZ.
Taxes are not normally withheld from unemployment compensation checks, so taxpayers can find themselves faced with an unexpected lump sum due come tax time. This can be avoided in at least two ways.
One, you can voluntarily elect to have money withheld from your unemployment benefits. By filing IRS Form W-4V, or an equivalent form provided by the payer of the benefits, you authorize 10% of your benefits to be withheld from each check to go toward taxes.
Two, you can pay quarterly estimated tax payments instead of waiting until April 15, thus breaking your tax bill into four pieces instead of a lump sum.
Of course in neither case are you actually reducing your taxes. This is solely a timing thing, if you’d prefer not to have your tax bill come due all at once on April 15 each year.
Not only are unemployment benefits now taxed at the federal level, they are also taxed at the state level in some states. So when you fill out your state tax form, you’ll need to ascertain whether you’re required to count your unemployment compensation as income in your state.