By the end of May 2020, over 20 million Americans claimed unemployment benefits.1 This payment can be a great relief to many who have found themselves out of work due to COVID-19. Many companies have been forced to lay off workers, while others simply have not been able to operate as a result of health risks, including restaurant and entertainment industry workers.
However, unlike the stimulus checks that were a part of the CARES Act and National Defense Authorization Act, unemployment benefits (state benefits plus the government’s weekly benefit payments) are federally taxable and may also be taxed by your state.2 Rather than facing an unwelcome tax burden during the 2020 tax season, we go through three options to help you prepare for this current tax season.
Option #1: Request Tax Withholdings
Since federal income tax is paid in real-time as you earn income, employers are required to withhold a certain amount from your pay throughout the year that goes directly to the IRS. This eliminates the need to monitor your salary and make regular payments to the IRS. When it comes to unemployment compensation, though, tax is not automatically withheld. However, the amount received is still taxed federally (and may be taxed in your state as well) — so you may end up owing at the end of the year.3
To avoid this, you can opt to have federal income tax withheld by submitting a request to the IRS using Form W-4V.3 There may be additional steps necessary to complete depending on your state of residency. You can check with your state’s requirements through the U.S. Department of Labor’s CareerOneStop.
Option #2: Make Estimated Tax Payments
In fact, the IRS recommends doing so if you don’t elect to have taxes withheld or if a portion of your income is not automatically withheld.4 Not only does this save you from owing a hefty amount during tax time, but it can help you avoid or fix any issues that may come up, such as underpaying on taxes unintentionally. The IRS states that you can typically avoid any penalties by paying nine percent of your tax throughout the year.5
To estimate your payments, the IRS advises using your previous year’s tax return as well as Form 1040-ES, Estimated Tax for Individuals. The payment considers your expected income and tax credits.5
If you began receiving unemployment compensation in April or June of 2020, the deadline to make estimated tax payments was extended from April 15 and June 15 to July 15, 2020. After that time, however, estimated tax payments were still required according to the normal schedule.5
At this point, making estimated tax payments for the 2020 year is no longer an option. If you continue receiving unemployment benefits throughout 2021, however, this option may be something to keep in mind or discuss with your tax professional.
Option #3: Put a Portion into Your Savings Account
In some dire cases, it might not be possible to make consistent tax payments or to have a portion of your benefits withheld. If this is the case, whenever possible, put away part of your benefits compensation into a savings account. If you already have at least a small emergency fund accrued for the year, delegating this portion for your taxes can help you prepare for the 2020 tax season.
For those who have experienced economic hardship and have needed to collect unemployment compensation, there are still proactive ways to ease your financial future. Saving for taxes, paying them as you go or requesting withholdings are three avenues to do so.
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