If you lost your job due to the recent pandemic, the economic downturn, or any other reason beyond your control, you may have received unemployment compensation to help you cope with the financial hardship. Unemployment compensation can be a lifeline for many people who are struggling to make ends meet.
But do you know that unemployment compensation is also taxable income? And that it is different from wages, and has different tax implications.
Read this article to find answers to the questions above and get everything you need to know about how to report your unemployment compensation on your tax return, and how to avoid common pitfalls and mistakes that could cost you money or get you in trouble with the IRS. Are you ready? Start reading now to the end.
- Know What Unemployment Compensation Is
- Understand the Taxation of Unemployment Benefits
- Know How to Report Unemployment Compensation on Your Tax Return
- Know Why Unemployment Compensations Are Not Wages
- Know the Relationship Between Unemployment, Tax Withholding, And Estimated Tax
1. Know What Unemployment Compensation Is
See Unemployment compensation as a type of income that you receive when you lose your job through no fault of your own. The reason for this compensation is to provide you with temporary financial assistance until you find another source of income.
Bear in mind that unemployment compensation is a broad term that covers various types of payments that you may receive when you are unemployed. According to the IRS, unemployment compensation includes:
- State unemployment insurance benefits
- Railroad unemployment compensation benefits
- Disability benefits as a substitute for unemployment compensation
- Trade readjustment allowances under the Trade Act of 1974
- Unemployment assistance under the Disaster Relief and Emergency Assistance Act of 1974
- Special unemployment assistance under the Airline Deregulation Act of 1978
However, don’t think unemployment compensation includes workers’ compensation or supplemental unemployment benefits that your employer or union pays. Other items that are not part of unemployment compensation are:
- Social security benefits
- Retirement or pension income
- Severance pay
- Sick pay
- Vacation pay
- Back pay
- Bonuses
- Commissions
- Tips
- Interest
- Dividends
- Capital gains
- Alimony
- Child support
- Gifts
- Inheritances
- Lottery winnings
- Gambling income
2. Understand the Taxation of Unemployment Benefits
Know that unemployment compensation is taxable income and you must report it on your federal income tax return. Depending on your total income and filing status, you may also have to pay state and local income taxes on your unemployment benefits.
The amount of tax you owe on your unemployment compensation depends on several factors, such as:
- Your filing status (single, married filing jointly, married filing separately, head of household, or qualifying widow(er).
- Your adjusted gross income (AGI), which is your total income minus certain deductions.
- Your taxable income, which is your AGI minus your standard deduction or itemized deductions.
- Your tax credits are amounts that reduce your tax liability.
- Your tax deductions are amounts that reduce your taxable income.
- Your tax exemptions, which are amounts that reduce your AGI.
To calculate your tax liability on your unemployment compensation, you need to follow these steps:
- Add up all your sources of income, including your unemployment compensation, wages, salaries, tips, interest, dividends, capital gains, alimony, pensions, social security, etc.
- Subtract any adjustments to income, such as student loan interest, IRA contributions, alimony paid, moving expenses, etc.
- Subtract your standard deduction or itemized deductions, whichever is higher. The standard deduction is a fixed amount that varies by your filing status and inflation.
- Apply your tax rate to your taxable income to get your income tax.
- Subtract any tax credits from your income tax to get your final tax liability.
3. Know How to Report Unemployment Compensation on Your Tax Return
To report your unemployment compensation on your tax return, file Form 1040, U.S. Individual Income Tax Return, or Form 1040-SR, U.S. Tax Return for Seniors. You also need to attach Form 1099-G, Certain Government Payments, which is a document that shows the amount of unemployment compensation you received during the year.
You need to receive Form 1099-G from the agency that pays you your unemployment benefits, such as your state unemployment office or the Railroad Retirement Board.
On Form 1040 or Form 1040-SR, you need to report your unemployment compensation on line 7, along with your other sources of income, such as wages, salaries, tips, interest, dividends, etc. You need to enter the total amount of unemployment compensation you received during the year, as shown on Form 1099-G, in the box “Unemployment compensation”.
4. Know Why Unemployment Compensations Are Not Wages
Are you aware that unemployment compensations are not wages? Yes, they are not payments for services that you perform. According to the IRS, you can think of wages as “all income from an employer-employee relationship, regardless of how the income is measured or paid.” Wages include salaries, commissions, bonuses, tips, fringe benefits, sick pay, vacation pay, severance pay, etc.
On the other hand, Unemployment compensations are payments for your loss of income due to involuntary unemployment. They are not the amount or quality of work you perform, but on the eligibility criteria that the law or the program that provides the benefits establishes. In addition, keep in mind that the IRS does not subject unemployment compensations to the same tax rules as wages.
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5. Know the Relationship Between Unemployment, Tax Withholding, And Estimated Tax
Remember that unemployment compensation is taxable income, but it is not subject to tax withholding unless you request it. This means that you may have to pay tax on the benefits when you file your tax return, or you may have to make estimated tax payments during the year to avoid underpayment or overpayment of taxes.
Use estimated tax as a method to pay tax on your income that is not subject to withholding, such as unemployment compensation, self-employment income, interest, dividends, alimony, etc. Note that tax withholding is the amount of income tax that your employer deducts from your paycheck and pays directly to the government.
It is a way of paying tax on income as you earn, rather than at the end of the year. Pay estimated tax quarterly, and you must base it on the expected income and tax liability for the year. To calculate your and pay your estimated tax, use the IRS worksheet and Form 1040-ES.
Consider making estimated tax payments if:
- You think you may owe at least $1,000 in tax for the year, after subtracting your withholding and refundable credits.
- You expect your withholding and refundable credits to be less than the smaller of:
- 90% of the tax you owe for the current year, or
- 100% of the tax you owed for the previous year.
However, you can avoid making estimated tax payments if:
- You have enough withholding from other sources of income, such as wages, pensions, social security, etc., to cover your tax liability for the year.
- You qualify for certain exemptions or waivers, such as:
- You have no tax liability for the previous year, and you are a U.S. citizen or resident for the whole year.
- You have a casualty, disaster, or other unusual circumstance that prevents you from making the payments.
- You retire or become disabled during the year or the previous year.
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Recap
Remember that unemployment compensation is a valuable source of income for millions of Americans who have lost their jobs due to various reasons. However, it is also a taxable income that you must report on your tax return. Failing to do so can result in penalties, interest, or audits from the IRS.
This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. . For comprehensive tax, legal or financial advice, always contact a qualified professional in your area. S’witty Kiwi assumes no liability for actions taken in reliance upon the information contained herein.
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