Unemployment Benefits and Taxes: Why You May Owe on Jobless Pay

Unemployment benefits can be a lifeline after a job loss. They help pay rent, groceries, and bills while you search for work. What surprises many people is that those benefits are generally taxable income at the federal level. If no tax was withheld, the bill can show up months later, when you file your return in the spring.

The good news is that you can plan for it now. Knowing how unemployment is taxed, how to have tax withheld, and what forms to expect can help you avoid a surprise tax bill or penalty. Here is what you need to know.

Why unemployment benefits are taxable

The IRS generally treats unemployment compensation as taxable income. That includes state unemployment benefits and certain other payments, such as some benefits paid under federal programs. You must report these benefits on your federal tax return.

Unemployment benefits are not subject to Social Security and Medicare taxes, the payroll taxes that come out of wages. But they are counted when figuring your federal income tax. Depending on your total income for the year, that could mean owing tax.

States vary. Some states tax unemployment benefits, while others do not. Check your state's tax rules or ask your state tax agency.

Have tax withheld from your benefits

You can choose to have federal income tax withheld from your unemployment benefits. Under federal rules, the withholding rate is 10 percent of each payment. You can request it by filling out Form W-4V or the form your state unemployment agency provides.

Withholding can help you avoid a large bill when you file. If you did not choose withholding when you first applied, ask your state agency whether you can start now. Some states also allow state tax withholding.

If you cannot afford withholding, set aside money from each payment in a separate savings account. Even a small amount each week can help cover the tax later.

Make estimated payments if needed

If you do not have tax withheld, or if 10 percent is not enough, you may need to make estimated tax payments. The IRS generally expects taxes to be paid throughout the year. If you owe too much at tax time, you might face a penalty.

You can make estimated payments online through IRS Direct Pay or your IRS online account. Estimated payments are typically due in April, June, September, and January. Check the IRS website for exact dates.

If you start a new job later in the year, you can adjust your Form W-4 with your new employer to have extra tax withheld from your paycheck. This can help cover tax owed on unemployment benefits received earlier in the year.

Watch for Form 1099-G

Your state unemployment agency should send you Form 1099-G early next year. It shows the total unemployment compensation you received and any federal tax withheld. You will use this form when you file your tax return.

Check the form for accuracy. If the amount is wrong, or if you receive a 1099-G for benefits you did not receive, contact your state agency right away. A 1099-G for benefits you never applied for can be a sign of identity theft.

If identity theft is involved, ask the state agency for a corrected form showing zero benefits. Report the fraud to the state and to the FTC at IdentityTheft.gov.

How unemployment affects credits and benefits

Unemployment benefits count as income for some tax credits and programs. They may affect your eligibility for the Earned Income Tax Credit or premium tax credits for health insurance through the Marketplace. Unemployment benefits do not count as earned income for the EITC, which may reduce the credit for some people.

If you buy health insurance through the Marketplace, report changes in income when your job situation changes. This helps make sure your premium tax credit is correct and avoids a surprise when you file.

Unemployment benefits may also count as income for other assistance programs, such as SNAP or Medicaid. Report income changes as required by those programs.

Repaying benefits

If you were paid unemployment benefits you were not entitled to and you repay them, the tax treatment depends on when you repay. If you repay in the same year you received the benefits, subtract the repaid amount from the total benefits you report.

If you repay benefits in a later year, you may be able to deduct the repayment or claim a credit, depending on the amount. The rules can be complicated, so check IRS guidance or ask a tax professional.

Keep records of any repayments and communication with your state agency.

If you cannot pay what you owe

If you file your return and owe more tax than you can pay, file on time anyway. Filing late can result in a separate penalty. Pay what you can, and look into an IRS payment plan, which you can often set up online. Interest and penalties may still apply, but a payment plan can make the bill manageable.

If you are facing financial hardship, the IRS may offer other options, such as temporarily delaying collection. Check the IRS website or call for information. Free tax help is available through programs such as Volunteer Income Tax Assistance for eligible taxpayers.

Keep good records

Keep copies of your unemployment application, benefit statements, and payment records. If your state agency changes your benefit amount or asks for repayment, keep those letters too. These records can help you resolve errors on your 1099-G and support your tax return.

If you worked part of the year, keep your W-2s together with your 1099-G so you have a complete picture of your income when you file.

If you are still job hunting, remember that some job search expenses are no longer deductible for most people under current federal law. Keep your focus on withholding, savings, and planning rather than counting on deductions. If you start a business or freelance work while unemployed, that income is taxable too, and you may owe self-employment tax. Track that income separately and set aside money for taxes. A free tax clinic or a tax professional can help if you have income from several sources.

If your state also taxes unemployment benefits, ask the state agency whether it can withhold state tax too. Some states offer it and some do not. If not, set aside a little extra for your state return.

Keep a copy of any withholding request you submit, and check your next payment statement to confirm the tax is actually being taken out.

Steps to take now

If you are receiving unemployment, check whether federal tax is being withheld. If not, consider starting withholding or setting aside money each week. If you received benefits earlier this year and are now working, consider adjusting your withholding at your new job.

Keep track of your total benefits and any tax withheld. When you get your Form 1099-G, compare it with your records.

The bottom line is that unemployment benefits are generally taxable, and planning ahead can prevent a surprise tax bill. Choose withholding if you can, set money aside if you cannot, and watch for your Form 1099-G. A little planning now can make tax season much easier.