Many people erroneously believe that state unemployment compensation is not considered taxable income, resulting in quite an unpleasant surprise at tax time when they realize their mistake. With a record number of Americans filing for unemployment benefits due to the Covid-19 pandemic and struggling to make ends meet, it’s important to plan ahead in order to not have a shortfall.
Unemployment Compensation is Taxable Income
While taxpayers don’t pay Medicare or Social Security taxes on unemployment compensation, they are still required to pay federal taxes on the income. Additionally, most states count unemployment compensation as taxable income, too. Currently, only California, Montana, New Jersey, Oregon, Pennsylvania, and Virginia do not require income tax to be paid on unemployment compensation. This also applies to states that don’t have state income taxes, such as Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming.
Establishing Withholding
If your state allows you to specify withholding, take advantage of it! However, it doesn’t necessarily mean that the amount withheld will satisfy your tax burden. Some states only calculate withholding on the state unemployment portion of the income, not on the additional $600/week federal pandemic unemployment compensation component.
To illustrate, say your weekly state unemployment compensation benefit is $300 and you qualify for the additional $600 federal pandemic unemployment assistance, giving you a combined weekly benefit of $900. You select 10% withholding, thinking that you will have $90 withheld, but notice that the actual withholding is only $30. Consequently, this lack of withholding could result in a balance owed at tax time.
How to Fix Under-Withholding of Taxes
If you are having little or no income taxes withheld from your unemployment compensation, the first step in making a course correction is to determine what your effective tax rate (not tax bracket—effective rate is the actual percentage of taxes you pay to the IRS) was for the prior year. While current year income may have trended up or down this year, knowing your prior year effective tax rate provides a good starting point. Compare that number to the percentage of tax that is being withheld from your unemployment compensation—if it is less, there’s a good chance you’re not having enough tax withheld and will owe when you file your tax return. Consider taking one or more of the following steps:
- If your state allows it, increase your withholding percentage on your unemployment compensation. If you are at the maximum amount of withholding and don’t believe that it will be sufficient, look to step 2 below.
- Make quarterly estimated tax payments. In order to avoid both a large balance owed at tax time and possibly neutralize an underpayment penalty, initiate quarterly estimated tax payments for the amount you believe you may be under-withholding. Using the example in the paragraph above where there is a difference of $60 not being withheld each week, a taxpayer could earmark those funds for taxes and remit an estimated tax payment to the IRS on a quarterly basis.
- Adjust withholdings on a secondary W-2. In a situation where you have a spouse who continues to receive W-2 income, consider increasing the amount of tax withholding on that activity in order to offset the lack of withholding on the unemployment compensation.