This tax trap could affect millions due to Covid. Here’s what you need to know
The 2020 tax season is officially on, and the millions of Americans who received unemployment benefits over the past year due to the coronavirus pandemic may be surprised.
This unemployment income is taxable and if you did not set aside or withhold money for these taxes it could reduce your refund or even result in a bill.
This may be unexpected especially for independent contractors and self-employed workers who are normally not eligible for government benefits but may have received pandemic unemployment benefits through the CARES law.
“This year there will be a lot of people who have unemployment insurance and typically don’t get unemployment insurance benefits,” said Elaine Maag, a research fellow at the Urban-Brookings Tax Policy Center. “So it will be something new to look out for.”
Differences in State and State Treatment
If you had unemployment income in the last year, it is taxable and must be reported on your 2020 income tax return. In January, those on unemployment income should have received a Form 1099-G detailing the amount of money paid out during the year.
Federal income taxes apply to these benefits – regardless of whether it is a state unemployment insurance scheme or a pandemic unemployment benefit paid out under the CARES Act.
The catch is that withholding the fair amount of income tax is voluntary. You can choose to have a flat rate of 10% of your benefits withheld to cover your tax liability.
To do this, you would need to submit Form W-V4 to the government agency that manages your unemployment.
You can also make quarterly estimated tax payments to the IRS.
Uncle Sam isn’t the only company looking for a part of your unemployment income. Most states will also tax these benefits.
A handful of states – Alabama, California, Montana, New Jersey, Pennsylvania, and Virginia – do not tax these payments. According to Andy Phillips, director of the Tax Institute at H&R Block, Indiana and Wisconsin offer partial unemployment income exclusion.
“Some states have withholding taxes; others impose it to ease surprises when tax time comes,” said Jared Walczak, vice president of state projects at the tax foundation.
While it’s too late to start deducting the taxes you may owe for 2020, people who complete their tax returns early can at least plan to pay the amount owed by April 15 – the due date for tax returns and liabilities.
“You don’t have to make a payment until April 15th, but it’s better to know in late January or early February that you’ll have to submit the dollar amount by then,” said Phillips of the Tax Institute at H&R Block.
Unemployment and tax credits
Families who received unemployment income in 2020 should also look for two key credits when filing their taxes: the Earned Income Tax Credit and the Child Tax Credit.
Both credits add up to sizeable dollars – the earned income tax credit is up to $ 6,600 for a low-income household and three or more qualified children. The refundable portion of the child tax credit is up to $ 1,400 per qualifying child.
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The catch? Unemployment benefits are taxable, but are not considered earned income.
Under normal circumstances, getting out of unemployment would result in a reduction in both credits when you file your tax return.
The legislature resolved this problem in the Covid Aid Act at the end of the year. When you file your 2020 taxes this year, you will have the option to use your 2019 income to calculate eligibility for the credit.
“If you’ve transitioned from being a wage earner to filing for unemployment, you may be affected,” Phillips said. “Using your 2019 income just to determine the size of your loan can be a huge benefit for taxpayers.”