Hundreds of unemployed Kentucky residents wait in long lines outside the Kentucky Career Center for help with their unemployment claims.
John Sommers II
Individuals receiving unemployment benefits this year could face a tax surprise in 2021: owing Uncle Sam or receiving smaller refunds.
Some 1.43 million people filed for unemployment last week, according to the U.S. Labor Department.
More uncertainty is ahead: The $600 weekly federal unemployment boost ended on July 31 and Congress hasn’t agreed on an extension of benefits.
While the additional unemployment income has helped millions of families get by, it can carry some unintended tax consequences that will surface next year.
The Century Foundation
“A big concern for a lot of people is that unemployment is taxable, especially for people who get a huge amount and don’t have withholding from other sources,” said Ann E. Kummer, CPA and partner at Kirshon & Co. in Poughkeepsie, New York.
“They could end up with a tax bill next year, and if we’re not in a better position economically, they’ll be hurting,” she said.
Short on withholding
Unemployment benefits are subject to federal income taxes, as well as state income taxes depending on the state where you reside.
That’s where withholding comes in. If you fill out Form W-4V, you can have 10% of your payment set aside for federal income taxes.
You can also opt to pay estimated taxes quarterly. The first and second quarters’ payments were due on July 15. Sept. 15 is the deadline for the third quarter, and Jan. 15 is the due date for the fourth quarter.
Failure to withhold enough tax could mean that unemployment recipients will owe Uncle Sam — or receive a smaller refund — next spring when they file.
Losing tax credits
Mladen Sladojevic | E+ | Getty Images
Low-income households face another problem, aside from falling short on withholding.
“The people who normally live paycheck to paycheck but are now making more money on unemployment are going to lose those earned income tax credits,” said Adam Markowitz, enrolled agent at Howard L Markowitz PA CPA in Leesburg, Florida.
For the 2020 tax year — the taxes you’ll be filing next spring — the maximum earned income tax credit can range from $538 for households with no qualifying children to $6,660 for those with three or more kids.
What you get will depend on your filing status and your adjusted gross income.
For instance, single filers with no children can’t earn more than $15,820 in 2020 to qualify (the cap rises to $50,594 in AGI for single taxpayers with three kids).
If a taxpayer’s income jumps up dramatically, he or she may see a drastic decline in tax credits next year. See below for an example from Markowitz.
• A single mother of a 12-year-old earns $25,000 a year. She has no withholding. In 2019, she received a refund of approximately $3,900, which includes the additional child tax credit — the refundable portion of the child tax credit — and the earned income tax credit.
• That same taxpayer earned $5,000 prior to the Covid-19 pandemic, but goes on unemployment for the remaining 36 weeks of the year. She receives $750 a week in unemployment benefits, and they’re extended until the end of the year.
• She will get a refund of about $1,900. This includes the earned income tax credit and the additional child tax credit.
“Yes, she made an extra $7,000 in total income being on unemployment, but her net difference when filing taxes is about $2,000,” said Markowitz.
Income that’s suddenly too high could also affect accessibility to the tax credit on premiums for individuals who buy health insurance on the exchanges, said Kummer. These credits offset the cost of coverage.
To qualify for a premium tax credit, your household income can be no more than 400% of the federal poverty line for your family size. In 2020, the federal poverty line is $12,760 for individuals ($26,200 for a family of four).
If a taxpayer’s income exceeds the 400% of federal poverty line threshold, they are no longer eligible for the premium tax credit and will have to repay it.
“If the unemployment bumps your income too much, you get the credit to offset premiums and then you have to pay it back,” Kummer said. “It can make next April very uncomfortable.”
A patch in the House
Speaker of the House Nancy Pelosi, D-Calif., at her weekly news conference in the Capitol in Washington on July 9.
Caroline Brehman | CQ-Roll Call, Inc via Getty Images
Withholding taxes could help avert the tax hit, but households that are squeezed and need every cent of their unemployment face a difficult choice.
“If you’re receiving unemployment benefits and you’re low-income, you’d want to make sure there’s food on the table,” said Oscar Vives Ortiz, CPA and member of the American Institute of CPAs’ personal financial specialist committee.
“If you find out you may owe, you should go to your state’s unemployment website and withhold 10%,” he said.
But a policy fix might be what it takes to head off a messy tax season for millions.
The House sought to head off these tax hiccups in its HEROES Act, the $3 trillion coronavirus relief bill it passed in May.
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The HEROES Act would have extended the $600 federal weekly unemployment benefit through January 2021. It also would have allowed taxpayers with less earned income in 2020 to collect the earned income tax credit based on their 2019 earnings.
Unemployment benefits aren’t considered earned income.
“When you calculate your 2020 earned income tax credit, if your 2019 earned income tax credit would’ve been larger, you’d have the option to take that credit,” said Meg Wiehe, deputy executive director of the Institute on Taxation and Economic Policy.
“This is a situation where it’s less about what the individual can do or what the family decides to do,” said Wiehe. “It requires a policy solution.”
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