Don’t Pay Tax on Unemployment Benefits

Wasson and ThornhillUnemployment Benefits

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Photo by Kelly Sikkema on Unsplash.

Did you receive unemployment benefits in 2020? 1 in 4 Americans did. Under the American Rescue Plan you don’t pay tax on the first $10,200.

Unemployment Benefits Are Generally Taxable

As the IRS states plainly, “[i]f you received unemployment compensation during the year, you must include it in gross income.” Unemployment Compensation, IRS Topic No. 418. Furthermore, “unemployment compensation” explicitly includes not just the usual “state unemployment insurance benefits.” It also includes “Federal Pandemic Unemployment Compensation provided under the . . . CARES Act of 2020.” Unemployment Compensation.

If you received unemployment benefits in 2020 you had the option of having income taxes withheld. Or you could have paid quarterly estimated tax payments. But you may not have been aware that unemployment benefits were taxable. Or money was so tight that there just wasn’t enough to have some of it withheld. And there wasn’t any money to pay estimated tax payments, if you even realized when those were due.

All of which means that you may have been dreading preparing and filing your 2020 income tax returns. You’ve been afraid of owing income taxes because of having received unemployment benefits in 2020. Or you hadn’t heard that those benefits were taxable but now you’re worried about it.

American Rescue Plan Exempts $10,200 of Unemployment Benefits

There’s some very good news about this. Because of the recently passed American Rescue Plan Act, you likely won’t pay federal income tax on the first $10,200 of those benefits. And you may not pay state income tax on it either, depending on the state.

To qualify, your adjusted gross income for 2020 must be less than $150,000. Section 9042(a) of the American Rescue Plan Act. This adjusted gross income maximum is the same even if you are filing jointly. If your adjusted gross income is $150,000 or more you aren’t able to exclude any unemployment compensation. IRS Post Release Changes to Forms, New Exclusion of up to $10,200 of Unemployment Compensation.

If you do qualify, this income exclusion applies to both traditional state unemployment benefits and the additional federal ones added in 2020.  U.S. Dept. of Treasury Fact Sheet, March 18, 2021.

Plus, “in the case of a joint return . . . each spouse” may exclude $10,200 of such benefits from gross income. Section 9042(a). However, that maximum does not increase for one spouse if the other did not receive any or less unemployment benefits. Each person can exclude no more than $10,200. Note that you CAN exclude as much as $20,400 of unemployment benefits if both spouses received $10,200 or more.

What about State Income Taxes?

Whether you pay state income taxes on unemployment compensation in general circumstances depends on your state. Now whether this new $10,200 exclusion applies also depends on your state.

In some states—California and New Jersey, for example—unemployment benefits are simply never taxed as income. Kentucky and Indiana both tax unemployment income, as do most states. Many other states automatically follow federal law regarding what income is taxed, so in these states the $10,200 exclusion should apply. However, again Kentucky and Indiana don’t. You need to check with your state’s taxing authority for information about whether the federal unemployment benefit exclusion applies. Here’s a list showing which states tax unemployment benefits, and which are “coupled” to this new exclusion of those benefits.

If You Haven’t Filed 2020 Tax Returns

Prepare your tax returns—or have your tax preparer do so—appropriately excluding the right amount of your unemployment benefits. Actually you’ll report your total benefit amount as income. Then you’ll separately exclude the right amount based on the IRS Unemployment Compensation Exclusion Worksheet. You can find that Worksheet at the end of these IRS instructions.  

If You’ve Already Filed 2020 Tax Returns

Have you already filed your income tax returns without knowing about this income exclusion? If so, you obviously want to take advantage of it. It will likely lower your tax liability and/or increase your tax refund. Depending on your tax rate, it could swing you in the right direction by about $1,000.

Common sense may tell you to quickly submit an amended return to take care of this. But not necessarily. This is what the IRS is saying at the moment:

If you have already filed your 2020 Form 1040 or 1040-SR, you should not file an amended return at this time. The IRS will issue additional guidance as soon as possible.

IRS, New Exclusion of up to $10,200 of Unemployment Compensation (reviewed or updated March 24, 2021).

Depending on the circumstances, filing an amended tax return could potentially actually slow things down. The IRS is dreadfully understaffed and is taking a long time to process both tax returns and especially amended ones. It may be quicker to let it process your original tax return, and potentially automatically exclude your benefits. This is what at least one state is saying in response to this specific situation:

You do not need to file an amended return. The [state department of revenue] will correct it for you, and, in most cases, you will receive a refund or have a lower tax bill.

Of course, talk with your tax preparer, if you have one. Or your Indiana or Kentucky bankruptcy lawyer. And keep checking back to these IRS webpages for updates on the topic of Unemployment Compensation and Coronavirus Tax Relief.