How will unemployment benefits impact your 2020 taxes

When COVID-19 upended businesses large and small, millions of Americans filed unemployment benefit claims.

According to the U.S. Department of Labor, 33.7 million people filed initial unemployment claims in the second quarter of 2020. Many, including self-employed people, filed for the first time in their careers.

If you're one of those millions, you might be wondering how to handle unemployment income on your 2020 tax return due April 15, 2021. Here's what you need to know.

Unemployment income is taxable

The Internal Revenue Service (IRS) makes this clear: “By law, unemployment compensation is taxable and must be reported on a 2020 federal income tax return. Taxable benefits include any of the special unemployment compensation authorized under the Coronavirus Aid, Relief, and Economic Security (CARES) Act, enacted this spring."

For most, “special unemployment compensation" includes the extra $600 provided for a time by the CARES Act.

On the bright side, the government doesn't withhold FICA—Social Security and Medicare taxes—from unemployment income.

It's not too late to adjust your withholding

During the unemployment claim application process, you could withhold 10% of your payment to cover part or all of your federal tax liability by completing Form W-4V, the Voluntary Withholding Request. If you didn't and wish you had, you might be able to make an adjustment.

“If you change your mind after you start receiving benefits, you may be able to update your withholding status either in writing or through your online unemployment portal," says Michele Slocum, CPA and manager with accounting and advisory firm Klatzkin.

To calculate whether you've withheld enough, use the IRS Tax Withholding Estimator.

If you didn't withhold enough and you're back to work, consider saving now. “If you haven't already started saving, you can set up automatic transfers of a portion of your paycheck into a savings account to save enough to pay your taxes in 2021," says Ben Reynolds, CEO and founder of Sure Dividend.

You will receive a Form 1099-G for your taxes

Form 1099-G will show the amount of unemployment compensation received during 2020 in Box 1, and any federal income tax withheld in Box 4. Report this information on Form 1040, Line 8, "Other Income" and Schedule 1 (Form 1040), Line 7, "Unemployment Compensation."

“If you don't receive Form 1099-G, contact your state's unemployment agency before filing your federal income tax return," says Nate Tsang, CEO of WallStreetZen.

Know whether you owe state income tax

These 15 states don't tax unemployment income:

• Alabama
• Alaska
• California
• Florida
• Montana
• Nevada
• New Hampshire
• New Jersey
• Pennsylvania
• South Dakota
• Tennessee
• Texas
• Virginia
• Washington
• Wyoming

In all other states, your unemployment income is taxable.

How to handle a larger than expected tax bill

Don't panic if you owe more than expected.

“If they do owe an amount that can't be paid within 120 days after April 15, I recommend they reach out to a professional who can help them deal with the IRS," says Timalyn Bowens, owner of Bowens Tax & Bookkeeping Solutions. “A CPA, enrolled agent, and tax attorney are the only people who can handle a tax matter on behalf of a taxpayer before the IRS."

Whatever you do, don't pay what's owed with a credit card, cautions CPA and entrepreneur Zach Reece. “It is way better to contact the IRS and ask to get your taxes paid as installments," he says. "Not only does your late fee get cut to 0.25% from 0.5%, you can choose to pay it over 72 months. The interest comes to 3% and is way lower than credit card interest rates."

To request an installment agreement yourself, apply online with the online payment agreement application or in writing with Form 9465, says Joshua Zimmelman, managing partner at Westwood Tax & Consulting LLC.

Knowledge is power. The more you know now, the better prepared you'll be come April 15.