Because of the far-reaching effects of COVID-19, a record number of Americans have made claims for unemployment benefits.

If you're one of them, it's important to realize these benefits are not tax-free. You need to know what your IRS obligations are so you're prepared to fulfill them and live on what's left over. 

1040 form with pen and calculator sitting on it.

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Unemployment benefits are subject to federal income tax -- but you won't owe payroll taxes on them

Unemployment benefits are subject to federal tax and, depending on where you live, you may owe state taxes as well. 

On the federal level, your benefits are taxed as ordinary income, so the amount you owe is based on your tax rate. However, there's one important difference -- you won't owe Social Security or Medicare taxes on your benefits. Typically, employers and employees each pay 6.2% in Social Security tax and 1.45% in Medicare tax, but you won't owe this on your unemployment income.

As for state taxes on unemployment benefits, the rules vary depending on where you live. In the seven U.S. states with no income taxes (Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming) you won't have to worry about owing. And in some other states where income is ordinarily taxed, including Pennsylvania, New Jersey, California, and Montana, unemployment benefits are excluded. But in most states, you are subject to tax just as if your benefits were income from a job. 

Here's how you'll pay tax on unemployment benefits

Since you'll owe federal (and possibly state) taxes on unemployment benefits, you have to pay the bill to the IRS. You have a few options for how to do that:

  • You can request to have taxes withheld directly from your unemployment payment

This is the simplest approach since you don't have to do anything extra. States determine how much to withhold based on how they calculate taxes on benefits, plus add on an extra 10% for federal tax.

The only problem is, your federal tax rate may be higher or lower than 10%. If you overpay federal taxes, that's not a big problem since you just get a refund. But if you underpay, you could end up getting hit with tax penalties. 

To determine if 10% is too much or too little, use the online IRS withholding estimator. You'll have to make some guesses about how much you'll make this year, though. 

  • You can make quarterly estimated payments

This involves submitting periodic payments to the IRS online or via mail using Form 1040-ES. If you owe state taxes, you can submit quarterly estimated payments to your state as well. 

Payments are normally due April 15, June 15, Sept. 15, and Jan. 15 for those who owe quarterly estimated taxes, but this year, the deadline for both the April and June payments has been extended by the IRS (and most states) to July 15, 2020. 

While sending in payments can be more of a hassle than just having money withheld, you can make sure you're submitting enough to avoid a tax penalty if the amount your state would withhold is insufficient. 

Be aware of the effect of higher benefits on your 2020 tax obligations

Because the Coronavirus Aid, Relief, and Economic Security (CARES) Act provided an extra $600 a week in unemployment benefits, many Americans will find they're making more than they did when they were on the job. This could affect your tax bracket as well as your eligibility for certain means-tested tax credits and deductions.

If you find yourself making more than you did before, be prepared that you may have a bigger bill or a smaller refund when you file your 2020 returns. Save the extra money now to cover what you're likely to owe so you'll have it available when it comes time to pay the IRS.