The Potential Tax Surprise of Unemployment Benefits
As is no secret, the business shutdowns and resulting economic malaise caused by the Covid19 pandemic has caused many workers to lose their jobs and self-employed business owners to have to shutter their businesses, at least for a time.
As a result, the unemployment rate soared to levels not seen since the Great Depression. Record setting numbers of people, numbering in the tens of millions, applied for and began receiving unemployment benefits, many for the first time in their lives. The state unemployment benefits were supplemented by additional benefits Congress included in the CARES Act, one of the relief bills enacted in response to the crisis.
This included benefits for the first time ever for self-employed individuals. The CARES Act included provisions that called for states to extend self-employment benefits to independent contractors and other self-employed persons who were out of work as a result of the pandemic, something that had never happened before.
Further, the Act increased benefits by an extra $600 per week layered on top of the regular state benefits. In many parts of the country, because of this boost in benefits, some workers were actually taking home more money from unemployment than what their previous paychecks were.
Unemployment benefits have been, and for many continue to be, an economic lifeline for millions of Americans. But with that lifeline comes an attached tax string. And for many, it may come as a surprise to know that such benefits received constitute taxable income.
That's right, unemployment must be claimed as taxable income when it comes time to file your 2020 federal income tax return. Further, most states (including Arkansas) tax unemployment benefits as well. In my years of practice as a CPA and tax practitioner, I have found this to be one of the most common, unpleasant surprises that befall clients receiving unemployment benefits for the first time, and quite often they are not prepared for the resulting taxes owed.
It appears to be no different today. In May, the company Credit Karma conducted a survey of more than 1,000 people who had lost their job due to the pandemic and were approved for unemployment. Of those surveyed, Credit Karma reported that 27% of respondents thought that their benefits were tax-free. Further, 25% thought they could not elect to have income tax withheld from their benefits, something we'll touch on in just a bit. This is just one of several surveys pointing to similar results.
The IRS, for its part, has been pushing the message that unemployment is taxable and that options are available for taxes to be withheld. In Arkansas, for instance, according to the Department of Workforce Services, you have the option of having federal taxes withheld at a rate of 10%.
Still, the word doesn't seem to be getting through to many benefit recipients. That, or as is likely in many cases, the immediate financial strain is just so great, that any reduction in benefits such as by withholding tax causes hardship, so a decision is made to forgo the option.
Either way, recipients of unemployment are left potentially exposed to an unwelcome tax bill at the end of the year, one that could also come with a penalty for underpaying taxes throughout the year.
If you are a benefit recipient and are now concerned you are in for an "April surprise" (April 15 being the tax return filing deadline), you may be wondering what to do.
First, take stock of where you are. Assess what your likely taxable income is to date, including your unemployment, as well as project forward income for the rest of the year. You can then determine a ballpark figure of your overall tax bill and compare it to the amount of tax you currently have paid in already. This will give you an idea if whether or not you might owe when filing your 2020 tax returns.
If you think you will owe, there are some options for you to deal with it.
First, if you are still receiving benefits, you can contact the unemployment agency and request that income tax be withheld by filing IRS Form W-4V. Be aware, however, that at a 10% withholding rate, this may not cover the shortfall with less than two months to go in the year, so take that into consideration.
Another option is to make estimated tax payments directly to the IRS or state. You do this by using Form 1040-ES for federal payments and in Arkansas, using Form AR1000ES, both of which can be found online.
Finally, of course, you can begin now setting aside money somewhere to pay the expected taxes owed when you file.
As I mentioned earlier, if you don't have enough paid in during the year to meet certain criteria, you could be subject to what is known as the underpayment of estimated tax penalty in addition to the income tax you owe. Space limitations prevent a deep dive into how that penalty works, but just know that the first two options presented above will at least reduce to some degree the penalty should it apply, where as simply putting the money aside for payment later will not, so be sure and take that into consideration.