Perhaps surprisingly, unemployment benefits count as taxable income in most cases. These may include not only unemployment benefits received through the state government but also disability benefits that substitute for unemployment benefits, as well as any unemployment benefits that are paid under the Disaster Relief and Emergency Assistance Act. If you are a member of a union, you generally will need to include any unemployment benefits that you receive because of paying union dues. Form 1099-G will state the total amount of unemployment benefits that you have received so that you can report them on your tax return.
There are certain exceptions to the general rule that unemployment benefits are taxable. If you make payments to a special union fund that are not deductible, unemployment benefits received through the fund count as taxable income only to the extent that they exceed your contributions. Similarly, if you make payments to a government unemployment benefits program that are not deductible, unemployment benefits through this program count as taxable income only to the extent that they exceed your contributions. If your payments to the benefits program have been deducted, however, all of your unemployment benefits received through the program will count as taxable income.
Withholding from Unemployment Benefits
Some (but not most) unemployed individuals choose to have tax automatically withheld from their unemployment benefits payments. The withholding will amount to 10 percent of each payment. You can make a request for withholding by submitting Form W-4V to the office that pays your benefits. If you change your mind, you can submit another copy of this form to stop withholding. You may want to consult the IRS withholding calculator if you are not sure how much would need to be withheld and whether withholding makes sense for you.
Alternatively, if your spouse has a job, you may want to ask them to adjust the amount that is automatically withheld from their paychecks. By increasing the withholding amount, you may be able to avoid paying taxes on your unemployment benefits or paying estimated taxes related to them.
Unemployment Benefits and Estimated Taxes
Unemployed people who do not choose the withholding option may need to pay estimated taxes throughout the course of the year. You will need to make these payments only if you expect to owe more than $1,000 in total taxes for the year. Even if you owe more than $1,000, you will not need to pay estimated taxes if you did not pay any taxes in the previous year or if the amount withheld from the paychecks for any job that you held in the current year will account for at least 90 percent of your total tax obligation. (You can read more here [link to estimated tax penalties page] about estimated taxes.)
Some unemployed people may feel concerned that they will need to pay a penalty if they fail to pay the required amount of taxes in any given quarter through estimated tax payments or withholding. Rather than taking out a loan to pay the required amount promptly, though, a taxpayer may be better served by simply absorbing the penalty. It amounts to about 3 percent interest, which is cheaper than the interest on a typical loan.