October 13, 2020
By Rahul Iyer
If you were impacted by COVID-19 and lost your job (or lose your job any other time), you likely earn unemployment benefits. While the money is a nice way to bridge the gap between jobs, it’s important to know that it’s not ‘free money,’ you will owe taxes on it.
Regular unemployment benefits (the coverage anyone receives when they lose their job) has always been considered income. This means you owe taxes, but not the same taxes you’d pay if you were employed.
As an employee, you pay Social Security and Medicare taxes on top of your regular income taxes. When you’re unemployed, you only pay the federal income taxes, not the Social Security and Medicare taxes.
However, your state may charge taxes on your unemployment benefits too. Some states don’t charge state tax, so if you’re lucky enough to live in Alaska, Nevada, Florida, South Dakota, Washington, Texas, or Wyoming you don’t have to worry about it, otherwise, you’re on the hook for state taxes too.
You have a few options when paying taxes on your unemployment benefits.
The easiest is to have the taxes withheld. When you apply for unemployment benefits, the system usually asks if you want taxes withheld. If you agree to have the taxes withheld, your state’s unemployment office will withhold the funds and disburse them accordingly. This takes the burden off you, as it should cover most or all of your tax liability depending on how the state withholds them.
If you don’t want the taxes withheld, you should pay quarterly estimated taxes. On the IRS website, use the tax withholding calculator to determine how much you may owe. Send the allotted amount into the IRS quarterly. You can make your payments online.
Making quarterly payments helps avoid underpayment penalties which the IRS charges if you don’t pay your taxes on time (as you earn the funds).
If you don’t withhold or pay estimated quarterly taxes, you’ll owe the full amount when you file your taxes. This is the most expensive way to manage your taxes because you’ll likely pay a late payment penalty on top of the taxes you owe. If you choose this option, make sure you put money aside monthly as you receive your income so you aren’t stuck with a large bill you can’t afford.
If you received unemployment benefits during the pandemic, you may have received an additional $600 for a brief period. Those funds are also fully taxable, but your state may or may not have withheld taxes on them.
The bottom line is make sure you are aware of your tax liability on the money you earn from unemployment. Treat it just like the money you’d receive from an employer and make sure you pay your taxes on time. It’s never pleasant getting a large tax bill at the end of the year, so plan accordingly to ensure you don’t get an unpleasant surprise.