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IRS Will Soon Issue Refunds for Tax-Free Unemployment Benefits

By Charlene Rhinehart, CPA - Apr 8, 2021 at 4:17AM

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Unemployment benefits caused a great deal of confusion this tax season. Fortunately, the unemployment tax nightmare that left many with reduced refunds or an unexpected tax bill is coming to an end.

The IRS announced that it will start issuing refunds in May to eligible taxpayers who paid more unemployment taxes than required for benefits received in 2020. But if you're still a bit muddled about how unemployment compensation affects your tax return, we've put together the latest updates to ensure you're on the right track. 

Excited woman reading  on phone.

Image source: Getty Images.

Taxes on unemployment benefits 

Unemployment benefits have been a hot topic this tax season. In 2020, millions of Americans suffered from job loss and were forced to apply for unemployment benefits to stay afloat during the pandemic. Unbeknownst to many, the additional income received from unemployment came with a cost. 

The tax laws state that unemployment compensation is typically taxable and must be included in gross income for the year. You can request taxes be withheld from your unemployment payments when you apply for benefits. For those who didn't elect to have taxes withheld, then they'd have to pay any tax in quarterly estimates or with their returns. 

The American Rescue Plan Act of 2021 was signed in March and temporarily revised the rules for taxation of unemployment benefits. It allows eligible taxpayers to report up to $10,200 of their compensation as tax-free income for the 2020 tax year. 

Your tax-free benefits are coming soon 

For those who hadn't filed their taxes before the unemployment exclusion was signed, the IRS released an Unemployment Compensation Exclusion Worksheet. Taxpayers can use this worksheet to calculate and claim tax-free benefits. 

But for the millions of Americans who filed taxes early, there was a bit of confusion around the next steps. The IRS urged taxpayers to wait and not file an amended return if they missed claiming the unemployment exclusion on their tax return. Recently, the IRS announced that early filers can expect to see an automatic tax refund this spring or summer. 

Do you qualify? 

Before you get too excited, let's make sure you are eligible for the tax waiver on unemployment benefits.

First, your modified adjusted gross income (MAGI) must be less than $150,000. This ceiling applies to all taxpayers. Single and married couples have to ensure their MAGI is under this amount to qualify. 

Next, determine how much your exclusion amount should be. Each taxpayer can exclude up to $10,200 of unemployment benefits from taxable income. Married taxpayers can exclude twice as much, but the calculation can get a bit tricky.

Let's say a married couple filing jointly had a combined income of $120,000. One spouse received $14,000 in unemployment compensation and the other received $6,000. It's tempting to assume that the couple can claim the full $20,000 in unemployment benefits, but that's not how it works.

The first spouse can only exclude up to $10,200 and the second spouse can exclude the full $6,000, making the total unemployment benefits exclusion amount $16,200 for the couple. Remember, you can't dip into your spouse's unemployment exclusion amount because each person is only allowed up to $10,200 of tax-free unemployment benefits. 

Wrapping up tax season 

If you already filed your tax returns and didn't get to claim the unemployment exclusion, just sit back and relax. The IRS will handle the next steps by issuing you a refund if you paid more taxes than you should have.

If you are still holding on to your tax return, take note of the deadlines. The IRS has extended the federal income tax filing and payment deadline for individuals from April 15 to May 17 this year. Taxpayers who request an extension will have until Oct. 15 to file their returns, but tax payments are still due on May 17. If you owe estimated tax payments that are due by April 15, this tax extension is not applicable. Also, make sure you check with your state tax agency for filing deadlines.

Taxes for unemployment benefits and other updates may make this tax season a bit more daunting. Work with a tax professional if you need additional guidance. If you'd rather do it yourself, see if you're eligible for the IRS free tax filing software. Gather all your paperwork now to ensure you're on track to meet the deadline. 

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