According to two separate surveys, 27%-37% of Americans believe unemployment compensation is not taxable. This number surprised us. - Our practice has a high percentage of performers, athletes and "industry folks" for whom unemployment is a way of life. Many of them know more about the system - particularly eligibility and payment rules - than we do. They are universally aware that UI is taxable - though they sometimes choose to ignore that fact.
Unfortunately for recipients, unemployment benefits are included in Taxable Income for Federal Purposes. Many states tax unemployment as well. Only California, Montana, New Jersey, Oregon, Pennsylvania and Virginia, exempt unemployment benefits. Seven states —Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming — do not have state income taxes (which kind of precludes taxing unemployment). This leaves unemployment taxable for state purposes in 37 states. Unemployment income is not subject to "employment tax" (Social security, self employment, Medicare of state disability) for federal purposes, nor in any state we know of.
Further, unemployment compensation is not qualifying income for the Earned Income Tax Credit. If you receive reduced income from wages, salaries, or self employment - unemployment compensation will not make up the difference for the EITC. Usually, the lower qualifying income results in a lower credit - leaving you short of the expected credit when you file your return.
UI's taxability has become an issue because 31 million Americans are presently unemployed - many of them first-time UI recipients - and apparently many of them unfamiliar with the tax rules for UI. Between UI's tax-ability, and its effect on the EITC, we'd guess a whole lot of people are due for a nasty surprise when they file their 2020 returns.[*1] What can they do to minimize the pain? (Most of you are not going to like the answer.)
First line of defense: Withholding from your Unemployment. - If you are going to be over the personal exemption threshold (and thus make the UI tax an issue), you can elect to have the state withhold Federal and state tax from each distribution. This is the tax equivalent of "remove the band-aid slowly - or all at once." You receive less money now to avoid a big hit (and possibly penalty and interest) later. If you go this route - have tax withheld at your marginal tax rate or as close to it as is comfortable.
Variation - Over-withhold from other income sources. - Our performers and industry folks are masters of this technique! Claim far fewer exemptions on your ordinary wage and salary sources than you are entitled to. The over-withholding on e.g. residuals and performance fees compensates for the lack of withholding on unemployment. The cat h for everyone else -- it may be very hard to predict whether you will have any more incidental income this year. That adds an element of risk to this strategy.
Estimated tax: Both the withholding and the "over-withholding" options are a bit hit and miss. None of us knows what the rest of this year will occasion. Estimated tax payments permit you the wisdom of hind sight. Estimates based on year-to-date actual income and anticipated withholding and credits qualify for exemption from the estimated tax penalty. [*2] They are also a bit more robust with respect to your "ability to pay" - since they are based on realized rather than fantasized income and obligations. The downsides: 1) You have to think about this in advance of the estimate due dates, 2) unless you have a relatively uncomplicated tax return, you may need professional help to prepare the estimates. That cost may negate any penalty reduction you may be seeking.
Talk to your tax advisor about which approach works best for you (be sure to ask about estimate preparation fees!). If you are in a DIY mood, take a look at the IRS Estimated Tax - Tax Withholding Tool Like most IRS taxpayer assistance software, the Tool is excessively complicated, hideously confusing, and ultimately quite lame. However, it points you in the right direction, alerts you to questions you need to ask, and (who knows?) might even cough out a usable answer (don't hold your breath on the last part).
Let us know if we can assist you with this - or any other tax matter.
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