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Unemployment Benefits: Avoid an Unwelcome Tax Surprise

Taxes and Unemployment Benefits

September 4, 2020

2020 has been a year of turbulence and has created chaos for many Americans including governmental issued shutdowns, quarantines, social distancing and potentially filing for unemployment. Both the United States and the State of Iowa set records for unemployment claims during the 2020 COVID-19 pandemic. Unemployment claims are down from the initial surge, but remain high compared to traditional levels as Congress continues to try to find ways to help distressed individuals and businesses. This blog is aiming to provide some clarity on the taxation of those unemployment benefits to prevent already distressed individuals from receiving additional bad news next tax season.

Navigating Tax Rules + Estimating Withholdings

It can be difficult to navigate the tax rules related to the various pieces of federal and state legislation and executive orders that have been passed to help during the pandemic. There has been a lot of talk related to loan forgiveness, monetary grants and supplemental benefits that may confuse people. The rules for unemployment benefits are straightforward and all unemployment compensation is taxable as ordinary income. Taxable unemployment compensation includes all benefits paid to an individual from a state of Federal Unemployment Trust Fund, including any special supplement benefits that were passed via the CARES Act this spring.

The good news is individuals receiving unemployment have the option to have federal and state taxes withheld from their unemployment benefits to help cover any associated taxes due. In Iowa, recipients can elect to withhold 10% of their benefit payment for federal taxes and 5% for Iowa taxes. The potential bad news is that the respective 10% and 5% may not be enough to cover the full tax liability, and other recipients may have elected not to have taxes withheld, leading to a surprise tax bill next spring.

Fortunately, there is still time in 2020 to adjust withholdings on unemployment — for those still receiving benefits — as well as on wages — for those who have returned to work. Individuals can start withholding taxes on their unemployment benefits by completing form 60-360 from Iowa Workforce Development here.

Individuals that have returned to work will want to let their employer know of any changes to their withholdings using IRS Form W-4. Prior to changing their withholding, these individuals can utilize the IRS Tax Withholding Estimator here. The Estimator will collect information from the individual and assess if they need to increase their federal withholdings to cover any estimated tax short falls. Individuals with complex tax situations may want to consult a tax adviser to assist in calculating the estimated tax shortfall.

In addition to adjusting withholdings, individuals can keep their withholding as is and pay quarterly estimated tax payments to cover the potential tax shortfall. These estimated payments can be made for the third quarter by Tuesday, September 15, 2020 and the fourth quarter by Friday, January 15, 2021 using IRS Form 1040-ES. The individual can use the IRS Tax Withholding Estimator to calculate the estimated tax due after withholding and pay this amount via the quarterly estimates to help avoid underpayment penalties.

Now is a good time to analyze your personal situation to plan accordingly to avoid a tax bill next spring.

You can count on The Partnership to continue to share accurate and fact-based updates. See more on COVID-19 here.

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Nate Beck, CPA

Nate Beck is a CPA with McGowen, Hurst Clark & Smith PC in West Des Moines providing businesses and individuals tax and accounting services to help increase their cash flow and overall success.