Unemployed workers could get a nasty surprise at tax time

If you’re one of the 25 million of workers who collected unemployment in 2021, you’ll owe income taxes on all those benefits this tax season — unlike last year.

Jobless benefits are generally counted as taxable income that taxpayers must report to the IRS. These include any of the special unemployment compensation programs passed by Congress during the pandemic, as well as regular unemployment insurance.

This may come as a surprise to workers who got tax relief for the first $10,200 of unemployment income they received in 2020 — a one-year break provided by the American Rescue Plan — especially since the change this year could shrink their tax refund.

“Beyond just people getting unemployment, the amount of unemployment people have gotten and how much they relied on it last year was multiples higher than usual. So many people had $20,000 or $30,000 in unemployment and that was just normal for last year,” Rus Garofalo, founder of Brass Taxes told Yahoo Money. “These same individuals got a tax break on the first $10,200 that was a big benefit to folks – that’s no longer available.”

“It feels particularly unjust that you paid into a system, needed help, and when you need help they want a cut out of your help,” said Garofalo.

‘Set aside money to pay off unemployment benefits’

Unemployment benefits are taxed like ordinary wages, but are not subject to Medicare or Social Security taxes. If you received unemployment compensation last year, you should receive a Form 1099-G from your state. This document will show the amount you were paid and the sum of federal taxes withheld — if any.

This is where it could get tricky, according to Garofalo. For instance, New York only withholds 2.5% of unemployment, but the New York state income tax can be higher than that and leave you owing, and nothing is withheld for New York City taxes. This means that taxpayers who didn’t withhold could get a smaller tax refund than expected — or none at all — because they could owe more than their refund.

“We had a lot of people owing a little bit or getting a small refund from the IRS if they had withheld taxes from their unemployment, but owing the state often a considerable amount of money,” Garofalo said. “Because the state of New York only withholds a very low percentage rate and the city doesn’t withhold at all, we had quite a few people somewhere around a couple of hundred dollars back from the federal government and owing $2,000 to the state and city of New York.”

To avoid this, the IRS recommends setting aside money to cover unemployment taxes. Typically, you can choose to have up to 10% of each payment withheld from your unemployment benefits for federal taxes with your state or unemployment office.

Recipients who didn't choose voluntary withholding, or don’t withhold enough, can opt to make quarterly estimated tax payments to the IRS.

“The circumstances when you receive unemployment, you’re not in the best state of mind for deciding if you’re going to set aside some of this money for taxes” Garofalo said. “It can be hard to make that choice when you need that money now. But when you have to deal with it, it can be quite a significant tax bill if you end up getting anywhere between $10,000 to $30,000 in unemployment.”

If you can’t make a lump sum payment on your tax bill, don’t put it on a credit card. According to Garofalo, the best practice is to start by paying off your state debt first as these carry higher interest rates than the federal government. Depending on the year, your federal debt can have an interest rate ranging from 3% to 5%, which is often much lower than state interest rates.

“For the federal government debt, I like to tell people to see it as a nice credit card with a low interest rate. They’ll give you up to six years to pay off your taxes, as long as you don’t ignore them for a long time,” Garofalo said. “They won’t do anything, they just want to get paid, and they are very understaffed so they don’t want to chase you around.”

Gabriella is a personal finance reporter at Yahoo Money. Follow her on Twitter @__gabriellacruz.

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