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How to Avoid Tax on Up to $10,200 of Unemployment Benefits

By Charlene Rhinehart, CPA - Mar 18, 2021 at 6:03AM

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If unemployment benefits put you in a hole on your 2020 tax return, you now have a better chance of getting a tax refund.

The American Rescue Plan Act of 2021 has saved the tax season for millions of Americans who received unemployment benefits in 2020. Instead of paying taxes on the full amount of unemployment benefits, the government is allowing eligible taxpayers to treat up to $10,200 of their benefits as tax-free income. 

Here are some of the latest updates from the IRS to help you determine if you qualify for the unemployment exclusion and how you claim it on your tax return. This tax waiver could turn around your entire tax situation and put more money in your pockets this year. 

Unemployment benefits application and phone displaying COVID-19 news

Image source: Getty Images.

How taxes for unemployment benefits usually work 

When unemployment checks started pouring in during 2020, many didn't realize that those benefits were taxable.

Your state unemployment benefits plus the weekly benefits are taxed as ordinary income by the federal government. Basically, you're subject to the same taxes you would pay on income earned from working a job, though you do not have to pay Social Security or Medicare taxes. Those are considered payroll taxes that you pay on earned income. You only have to worry about federal income taxes and possibly state income taxes. 

To avoid a tax nightmare, there is an option to have taxes taken out of unemployment benefits. But if you missed the memo, you may take a hit during tax time. 

Tax waiver under the latest stimulus bill

Fortunately, the American Rescue Plan Act that Congress passed and that President Biden signed on March 11 provided temporary relief for those who received unemployment benefits. 

Before the act passed, taxes on unemployment benefits were putting many taxpayers in a bad position when they filed their annual tax returns. If you did not elect to have taxes taken out of your unemployment compensation in 2020, you may have been stuck with an unexpected tax bill. Essentially, unemployment benefits would have eliminated the refund check many expected to receive. 

That's why the new COVID bill is a big deal for recipients of unemployment benefits. Certain taxpayers who received unemployment benefits in 2020 can now exclude up to $10,200 of compensation from taxable income. Married taxpayers can exclude up to $20,400. To be eligible, your modified adjusted gross income (MAGI) must be less than $150,000. 

Filing your tax return 

According to the Tax Foundation, more than 45 million tax returns have already been filed with the IRS for this tax season. If you've already filed your 2020 tax return, the IRS urges you to not amend your tax return at this time. 

For those who haven't filed their 2020 tax return yet, the IRS has issued more guidance to help you take advantage of the unemployment exclusion.

First, make sure you download your Form 1099-G Certain Government Payments to report the total unemployment compensation you received in 2020. This amount should be reported on line 7 of your Schedule 1 to Form 1040. This is the line for unemployment compensation.

If you and your spouse both received unemployment compensation, the total amount would be reported on line 7. Let's say you received $15,000 of unemployment compensation and your spouse received $8,000. You would report $23,000 on line 7. We'll get into the calculation for the unemployment exclusion next. 

Completing the unemployment worksheet 

The IRS has released an Unemployment Compensation Exclusion Worksheet that will assist you in doing the necessary calculations to claim your tax-free benefits. 

The worksheet will ask you to provide total unemployment compensation, calculate MAGI, ensure you haven't exceeded the income threshold, and calculate the amount you can exclude from unemployment compensation. 

Using the above example for the married couple, you would report $18,200 on line 8 as a negative amount (in parentheses). The $18,200 is reported separately from total unemployment compensation, representing a $10,200 maximum unemployment exclusion for you and an $8,000 exclusion for your spouse. Remember, you're not allowed to exclude any unemployment compensation if your MAGI is $150,000 or more. The worksheet will guide you to ensure you've met the requirements.

Another source of tax-free income 

Gaining access to tax-free income doesn't happen often for the average American. If you were unemployed last year and received benefits, consider this a home run on your tax return. 

In addition to the unemployment compensation, you'll still get tax-free benefits from the standard deduction if you don't itemize. In a season where unemployment is high and many are fighting to survive, every penny counts. Make sure you work with a tax professional or use the IRS free tax filing software (if you qualify) to claim all the benefits that will make your life a bit easier this year. 

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