NOTE: As we go to press, the US House of Representatives is expected to vote today (Tuesday) on the latest COVID-19 relief legislation. There are changes in unemployment compensation, particularly regarding the non-taxability of the first $10,200 of benefits received in 2020 for most taxpayers.
EDIT: Many tax preparers report that their software now accounts for the exclusion of unemployment benefits. Even better news: the IRS says it will likely automatically process refunds for taxpayers who have already filed. "We believe that we will be able to automatically issue refunds associated with the $10,200.”
In addition to the tragic loss of life and health, it didn’t take long for the COVID-19 pandemic to cause widespread financial damage. By the end of May 2020, large companies had laid off workers, small businesses were struggling, and health risks had devastated the entertainment and restaurant industries. More than 20 million Americans had claimed unemployment benefits by that time,1 which provided much-needed relief for those who found themselves out of work.
Unlike the stimulus checks that have been a part of COVID-19 relief legislation, unemployment compensation is federally taxable; your state may tax it as well.2 While it may be too late to change a lot about your 2020 return, what should you do to prepare for your 2021 taxes?
As we go to press, the American Rescue Plan Act is back in the hands of the U.S. House of Representatives after modification and approval by the U.S. Senate. The best information currently available tells us that bill affects the tax on unemployment compensation received in 2020, but not in 2021 or beyond. So, here’s what you can do to avoid a major tax hit this time next year.
Option #1: Request Income Tax Withholding
Any unemployment compensation benefits you receive are subject to federal income tax. But income tax is not withheld automatically from unemployment compensation. This can leave you with a large bill to pay when you file your tax return.
To avoid this, you can opt to have federal income tax withheld by submitting a request to the office paying your unemployment compensation using Form W-4V. There may be additional steps necessary to complete depending on your state of residency. (The Ohio Department of Job & Family Services asks claimants whether they would like to have tax withheld, but the amount isn’t always enough to cover the entire tax liability.) You can check with your state’s requirements through the U.S. Department of Labor’s CareerOneStop.
Option #2: Make Estimated Tax Payments
If you don’t elect to have income tax withheld, the IRS recommends making estimated payments.3 IRS publications emphasize that federal income tax is a pay-as-you-go system. Estimated payments not only save you from owing a hefty amount at tax time but can help you avoid underpayment penalties for failure to pay as you go. Your state likely has similar requirements.
To estimate your payments, the IRS advises using your previous year’s tax return as a guide, as well as the Estimated Tax Worksheet in Form 1040-ES, Estimated Tax for Individuals. Your tax preparer can help you identify how much you should pay in quarterly estimates.
Option #3: Set Aside Money in Your Savings Account
In some cases, it may be impossible to make consistent tax payments or have a portion of your benefits withheld. In this case, save part of your benefits in a savings account. It may seem hard to save for next year’s tax bill if you’ve lost your job, but doing so now is better than owing more than you have available in 2022. It won’t protect you from the underpayment penalties you’d avoid if you followed the pay-as-you-go method, but it will give you something toward the large tax bill that could be waiting next April 15.
COVID-19 has caused uncertainty in numerous forms for people across the country. For those who have experienced economic hardship and have collected unemployment compensation, there are proactive steps you can take to meet your future financial responsibilities. If you need additional assistance with your taxes, contact your tax preparer or financial advisor.
Be sure to check out our most recent video, what does the student loan crisis mean for parents.