If you collected unemployment benefits in 2021, you may be wondering if you have to pay taxes on the money you received. The short answer is yes.
That’s a big change from last year when you filed your 2021 tax return on your 2020 income. For 2020 federal tax returns, the American Rescue Plan of 2021 allowed the exclusion of up to $10,200 per individual, but that tax break wasn’t extended for 2021.
As the April 15 income tax filing deadline approaches, you need to be prepared to pay federal taxes on the unemployment compensation you collected in 2021. You could be hit with some sticker shock. Here’s what to know.
WHY UNEMPLOYMENT BENEFITS ARE TAXABLE
Unemployment benefits are treated as regular income. Your benefits get reported to the IRS and are subject to federal income tax. The amount you received during the year gets added to your overall taxable income. Although the benefits aren’t specifically taxed (nothing is withheld unless you opt-in), it’s that total amount of income that shapes your tax bill.
Most states with a state income tax also collect taxes on unemployment benefits, but some do not. Check the table at the end of this article to see if your state taxes unemployment benefits and what the rate is. You can find more details about each state’s approach in this guide.
The main difference between unemployment and regular wage income is that you don’t pay Social Security or Medicare taxes on unemployment benefits (listed as FICA taxes). Also, the percentage you pay for your benefits is determined by your income bracket. For example, if you’re a single filer and you earned between $9,951 and $40,525, you fall in the 12% federal tax bracket for 2021-2022.
HOW TO HANDLE A TAX BILL IF YOU’RE STILL UNEMPLOYED
You may be feeling the financial pinch if you’re still unemployed. If you can’t afford to pay your tax bill, the IRS offers a few options.
First, contact the IRS right away to explain your situation and find out if you’re eligible for an alternative payment plan. They can discuss your options with you and set you up on a repayment plan, such as a short-term repayment plan within 180 days or a long-term installment plan over 72 months. It’s peak tax season right now, so it may not be easy to get through right away. Try to be patient.
If you’re not able to pay anything at all, the IRS may decide your account is “currently not collectible.” That designation temporarily delays their collection process.
Keep in mind, that your tax debt doesn’t go away. Penalties and interest may accrue on the unpaid amount during this “not collectible” period. You’ll also be expected to pay fees and interest on any installment plan as well. Going forward, if you can afford to pay a little bit toward next year’s tax bill, that’s advisable to avoid a lump sum in April.
HOW TO AVOID A HEFTY TAX BILL ON UNEMPLOYMENT BENEFITS
To avoid being socked with a large bill come tax time, you can voluntarily choose to withhold a portion from your unemployment benefits so you don’t get stuck with a tax bill or lose out on a refund you were expecting.
Unless you absolutely can’t manage to pay throughout the year, it’s highly recommended you opt into withholding a certain amount. The agency that pays your unemployment benefits will withhold a flat 10% to cover all or a portion of your tax bill.
Once you’ve returned to work, it’s worth making sure you have the correct amount withheld to avoid a surprise bill. Use the IRS tax withholding calculator to see how much you should withhold.
WHAT ELSE TO KNOW ABOUT UNEMPLOYMENT TAX WITHHOLDING
Even though the IRS recommends you withhold a certain amount from your unemployment benefits to cover taxes, your well-being comes first. Of course, avoiding a big tax bill is preferable, but if money is extra tight, it’s more important to pay your utility bills and keep food in your pantry. You can always work out a way to repay your bill with the IRS later. Better that than letting your fridge go unstocked.