If you were laid off due to the coronavirus or became unemployed this year for other reasons, you may not fully understand the tax implications of this change in employment status. For some Americans, this uncertainty is already causing financial stress. A recent survey by TaxAudit found that 37% of taxpayers who are receiving or have received unemployment benefits during COVID-19 are concerned they may owe an increased amount of taxes next year.
While this is a valid concern, there are steps you can take now to ensure you’re prepared for tax season when it rolls around in the spring.
Last updated: Jan. 5, 2021
If you’re unemployed and are owed a tax refund, getting that refund early can help tide you over until you find a new job.
“File early in order to receive any potential refund as soon as possible,” said Cheryl Prout, partner at The Bonadio Group.
Be Aware That Unemployment Benefits Are Taxable
In general, any unemployment benefits you receive are taxable.
“While you will typically withhold federal taxes on unemployment, you should check to see if you are withholding enough as your tax bracket would have an implication on whether you under-withheld or over withheld,” said Mike Savage, CEO of 1-800Accountant.
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State Taxes May Not Automatically Be Withheld From Unemployment Benefits
While federal taxes are usually withheld automatically, state taxes may not be.
“Some states may tax unemployment benefits on the state level, while others may not,” Savage said. “You should check with your state to see if the amounts are taxable, and remit estimated payments ahead of time or set aside funds to pay the taxes if/when they come due.”
According to the Tax Foundation, of the 41 states that have income tax, five states completely exempt unemployment benefits from tax — California, New Jersey, Oregon, Pennsylvania and Virginia.
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Job Termination Income Is Also Taxable
In addition to paying taxes on unemployment benefits, you must also pay taxes on any job termination income you received.
“Severance pay — including payment for unused vacation or sick days — is fully taxable to you in the year that you receive it,” Prout said. “Those amounts will be included on the W-2 form you receive from your former employer.”
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If You Picked Up Contract Work During Your Unemployment, Be Aware of How That Changes Your Tax Situation
Perhaps you’ve done some contract work or picked up a part-time gig to make ends meet while in between full-time work. It’s important to know how this income is taxed — as well as the possible tax advantages of working as an independent contractor.
“If you picked up another job working as an independent contractor or were self-employed, you’ll need to pay taxes on that income as well, and you may or may not receive a 1099-MISC or 1099-K depending on the amount of income you received from those sources,” said Ralph Carnicer, VP of business development at Taxfyle.
“Keep in mind that you will be able to deduct any expenses related to that income — i.e., mileage, maintenance, equipment purchases like a computer or smartphone, your cell phone bill and a prorated portion of your home expenses (electricity, mortgage/rent, etc.) if you separate a space in your home for a home office.”
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You Can't Deduct Job Search Expenses
If you were hoping to deduct job search expenses, you’re out of luck.
“Job-hunting expenses such as travel and job placement company fees, unfortunately, are no longer deductible,” Savage said.
You May Qualify for New Tax Credits
Although you can’t deduct job-search expenses, you may now qualify for tax credits that you previously were not eligible for.
“Depending on your income level after going on unemployment, there may be credits available, included the earned income tax credit, the child tax credit, the child and dependent care credit and the retirement savers credit,” Prout said.
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State and Local Benefits Programs Are Generally Not Taxable
If you’ve been taking advantage of state and local government benefits — or want to — note that you usually don’t have to worry about paying taxes for these services.
“Many programs, such as the Supplemental Nutrition Assistance Program and housing and childcare subsidies, are generally not taxable,” Savage said.
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If You Can't Pay All the Taxes That Come Due, Consider an Installment Plan
Paying any taxes you owe may be a struggle if you are still out of work when Tax Day rolls around. Fortunately, you have repayment options.
“If you are not able to pay your taxes when you file your return, you should be aware that you can go into installment agreements with the IRS to pay your taxes due over time,” Savage said. “The application process is typically straight-forward — it is better to file your return and enter into an installment agreement than to not file your tax return at all, as failure to file penalties can be quite hefty.”
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There Are Advantages To Being in a Lower Tax Bracket for the Year
“Those who have been unemployed for most of the year will likely be in a lower than normal tax bracket for 2020,” said Moswen James, enrolled agent at Get Help Tax and Bookkeeping. “If that is the case, it might be wise to consider converting money from your traditional IRA into a Roth IRA. The conversion will mean paying taxes now but, if you have a while before you retire, the money in the Roth IRA account will be able to grow tax-free.”
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