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Unemployment benefits: Do you have to pay taxes on them?

June unemployment drops to 11.1%
June unemployment drops to 11.1% 02:11

More than 34 million workers had requested unemployment benefits as of the end of June, representing about 1 in 5 workers. While the government aid is helping many of them weather the coronavirus recession, they'll also have to pay taxes on those benefits — an issue that many might be unaware of.

Almost 1 in 3 people who are receiving unemployment wrongly believe they don't have to pay taxes on the assistance, according to a recent survey from Credit Karma. That could lead to unpleasant surprises for many workers come April 15, 2021.

Unemployment aid has been boosted by an extra $600 a week that was authorized by the Coronavirus Aid, Relief, and Economic Security Act, or the CARES Act, in March. While that extra pay will end later this month, jobless workers will continue to collect their state's regular unemployment benefits, which average about $333 nationally but range from a low of $101 per week in Oklahoma to a high of $531 in Massachusetts, according to the Center on Budget and Policy Priorities. Over time, those payments will add up — as will the taxes owed on those benefits.

"Many people falsely believe unemployment benefits aren't taxable," said Christina Taylor, head of tax operations at Credit Karma Tax. "However, it's important for people to know unemployment compensation is generally subject to income tax."

That's also true for people who live in states with individual income taxes, she added. If people who have collected unemployment benefits fail to withhold taxes or save a portion to put toward their 2020 tax bill, they could be in a tough financial spot when tax day arrives next year. 

"Ultimately, if you don't pay enough toward your income tax obligations you could end up with a tax bill – and possibly penalties and interest – when you file your tax return for 2020 in 2021," Taylor added.

How can you avoid a tax hit?

The first step is to ask your state's unemployment office to withhold federal income taxes automatically from your benefit check, Taylor noted. 

Another option is to pay the IRS for your estimated taxes on a quarterly basis, like self-employed workers do. Because the U.S. has a pay-as-you-go tax system, workers are required to pay taxes on income as they receive it throughout the year.

While you could wait and pay owed taxes in a lump sum next year, there are some downsides. For one, some people may not have the discipline to set aside the money into a savings account, leaving them short-handed when the tax filing deadline arrives. 

Secondly, if you don't pay enough throughout the year, you might not only be facing a big tax bill but a penalty from the IRS for underpaying your taxes, Taylor said.

"If the unemployment benefits leave you with extra cash at the end of the month, consider putting that extra cash into savings," she added. Credit Karma found that almost two-thirds of survey respondents said they were able to save some of their unemployment benefits, she noted.

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