Is Unemployment Taxable? (Guide to Taxes on Unemployment Benefits)

Lots of Americans use unemployment benefits insurance to pay their bills while they’re looking for a new job. Many people consider it free money that can help you get by in dire times. But is unemployment taxable? Unfortunately it is, and for that reason, it’s best not to consider it “free money.”

Your unemployment benefits are taxed like income, and you’ll have to pay those taxes on unemployment during tax season when you file your return.

Sometimes, the Federal government accidentally overpays a huge amount of money in unemployment benefits. If you were overpaid unemployment, you might have to repay it come tax season.

When it comes to collecting unemployment overpayments, the Federal Government only recovers about a quarter of its losses. In fact, there’s even a procedure in place for those who have received overpayments but aren’t able to pay the money back; they might be able to waive the repayment amount and subsequent fees. The only criterion is that the recipient must prove that they did not set out to purposely deceive the Federal Government.

Unemployment Eligibility Requirements

The U.S. Department of Labor Unemployment Insurance Program provides benefit payments to newly unemployed workers who lost their job “through no fault of their own.” If you’re an employee of the Federal Government, you may be eligible for unemployment during a Federal shutdown.

States are generally allowed to interpret that condition in their own way. But, for all intents and purposes, workers who are fired are usually not eligible for unemployment benefits. You’ll be eligible for unemployment benefits if you were laid off from your job due to budget cuts or downsizing.

If you lived in one state and worked in another, the laws of your employer’s state will apply, and not the laws of your state of residence.

It’s important to understand that unemployment benefits are not supposed to be your primary income. It’s only a temporary source of income that’s meant to help you cover some living costs while you search for another job. The amount of benefits that you receive is not dependent on your financial needs or lifestyle; a government formula will determine how much you receive.

If you’re going to collect unemployment benefits, you must be ready, willing, and able to work, and you must make a genuine effort to find new employment. There is usually a minimum number of jobs that you’re required to apply or interview for, so if you’re going to claim unemployment, it’s best to spruce up your resume and start scrolling through job sites.

You should keep detailed records of your job search efforts, whether they’re by phone, email, mail, online, or in-person. Your state’s unemployment authorities might demand to see your records at any time for proof that you’re making an actual effort to find work. Many states require that you report your job search activities weekly.

Whenever you’re in a financial bind, it’s helpful to reign in your spending as best you can and determine what your most minimal living costs can be. Use a budgeting app to help keep you from running through your unemployment funds faster than you can get a new job.

Types of Unemployment Tax Breaks

In the past, you could deduct a number of expenses related to your job search, like transportation, relocation costs, and seminar fees. Unfortunately, these deductibles were eliminated by the 2017 Tax Cuts and Jobs Act. But there are still certain ways you can find financial relief during unemployment.

EITC Eligibility

The Earned Income Tax Credit (EITC) is a tax break for workers who don’t have a very large income. If you’ve earned income during the year (not including your unemployment benefits), you might be able to use that amount to make a credit claim. Single taxpayers can claim EITC, but workers with dependent children benefit from it the most.

Starting a Business

There are lots of people who, when unemployed, decide that they’re going to go into business for themselves. The IRS has three categories of tax deductions for startup businesses:

• Creating a business/investigating creation of business: Deductible costs might include surveying markets, analyzing cost of products, exploring potential business locations, and other early costs.
• Preparing the business to open: Deductible costs might include employee training, travel expenses, advertising expenses, and consultant fees. Equipment cost is not deductible, but you may be able to claim future tax deductions on depreciation.
• Organizational costs: Deductible costs might include legal fees, state organizational fees, and initial salaries. You might need to have your business legally established within the end of the first fiscal year to claim these deductions.

Cash-Out Retirement Plan Early

If your unemployment has left you in a dire financial situation, you could consider cashing out your retirement plan and using it as emergency funds. Typically, there’s a 10% early withdrawal fee, but the IRS allows taxpayers to cash out their retirement plan tax-free if it’s a “hardship withdrawal.”

Of course, you shouldn’t tap into your retirement savings without careful consideration. You should only do so if there’s no other sort of financial relief you can get, and if you’re facing homelessness or illness due to inability to pay medical expenses. If you do decide to cash your retirement funds, then you should come up with an aggressive financial plan to replenish your retirement fund once you’re employed again.

How Unemployment Overpayments Happen

The most common reason for overpayment is attributed to clerical errors that qualify an applicant for regular payment when that person would normally not have qualified for unemployment benefits. That includes people who quit their jobs, were fired for negligence, who aren’t actively looking for work, or who have found another job.

The overpayment amounts are significant, especially when viewed through the lens of strained state budgets: Colorado once overpaid by $128 million in a single year, while Indiana paid out more incorrect benefits than correct ones.

Withholding Tax Now vs. Paying It Later

Overpayments aren’t the only concern for the unemployed. Even though taxes aren’t taken out of your unemployment check, you’re still expected to pay taxes on the benefits you collect, which is taxed as regular income.

Additionally, any supplemental benefits coming from company-funded programs are not taxed as income, but as “wages.” That means that you’re going to get a W-2 for them at the end of the year, and the IRS will tax you then.

In some states, you have the option to collect taxes that are withheld at the time the unemployment check is issued. Generally, 10 percent is withheld from the check. This withholding is optional, and recipients can elect to collect the entire amount and pay taxes on it at the end of the year instead.

Collecting a larger check is tempting, but it’s wise to have the taxes withheld from your unemployment check. Taking a hit now is better than owing the IRS at the end of the year. If you end up with a tax refund at the end of the year instead of owing, that money can go toward any bills you incurred as a result of being unemployed.

If you still decide to not have tax withheld from your unemployment benefits, make sure to set aside a portion of each check (say 10 percent) in a high-yield, interest-bearing account.

Reporting Unemployment on 1099-G

When you receive unemployment compensation, you will get issued a 1099-G at the end of the year. This is how the IRS keeps track of any income received from governmental sources. You are required to report this as income, and failing to do so might be one of the biggest tax mistakes you can make.

If you fail to report your unemployment benefits as income, it’s unlikely you’re going to end up federal prison for tax evasion. But the fees and penalties associated with lying on your taxes are significant. And if you get audited (even if all your other finances are clean) the process will be time-consuming and potentially expensive. When it comes to paying taxes, honesty is always the best policy.

Reporting unemployment income on your taxes is easy. There are lines on your tax forms that are specifically for any 1099-G income.

FAQs

Why did I receive a Form 1099-G?

You received Form 1099-G because you received unemployment benefits during the year. You’ll report the funds that you received on Form 1099-G.

How do I report this unemployment information on my income taxes?

If you received unemployment benefits, you’ll receive Form 1099-G in the mail. Report your unemployment on this form.

I never received Form 1099-G?

If you never received Form 1099-G, but you did receive unemployment benefits for the tax year, you’re still obligated to report your benefits on Form 1099-G when you file your taxes. Failure to do so may result in heavy tax penalties and fees. Order the form on the IRS website, fill it out, and include it with your tax return. 

Can I get my Form 1099-G information online?

Form 1099-G is not available online. You can mail-order the form here.

May I send an inquiry regarding my Form 1099-G by fax or mail?

Yes! You may send an inquiry via mail or fax. However, your information can’t be faxed back to you due to confidentiality concerns, so it’ll be returned to you via mail.

Why is my overpayment, which I repaid, not reported on my Form 1099-G?

The IRS handles overpayments separately from your tax return. If you were subject to non-fraud overpayment (in other words, if the overpayment wasn’t your fault), then you would receive a notice from the IRS telling you whether or not you must repay the overpayment. If you already repaid your overpayment, and you receive an IRS notice demanding repayment, you should contact your local IRS office.

For more information on unemployment benefits, visit IRS.gov.