Is My Client’s Unemployment Income Taxable?

The IRS announced a new Unemployment Exclusion for some taxpayers. If you have already filed your client’s taxes, there is most likely no need to file an amendment. The IRS will begin to recalculate the changes this spring, with the first refunds scheduled to be sent out this weekend. If you have not filed your client’s taxes, our software is up to date and will help you calculate the exclusion. 

For more information, read this IRS release.  

Many of your clients may have received unemployment compensation for the first time in 2020 due to COVID-19. They may be wondering if it is taxable or if it will affect their refund. We answer those questions and more in this article.   

Is my client’s unemployment compensation taxable?   

Yes, your client’s unemployment income will be taxed at the federal level and probably at the state level if their total income is more than the minimum required to file. It’s important to note that taxable benefits for tax year 2020 include any special unemployment compensation authorized under the CARES Act or under the second stimulus package bill.   

How did the American Rescue Plan affect unemployment compensation and taxes? 

The American Rescue Plan states that the first $10,200 of unemployment income for those who make less than $150,000 per year will not be taxable on your client’s 2021 return. If your client is married, each spouse is eligible for this exclusion, for a combined total of $20,400. If your client’s AGI is $150,000 or more, they will not be able to take this exclusion.  

How do I take this new exclusion in TaxSlayer Pro? 

As a preparer, you may be wondering how to take this exclusion for your clients who have not filed their taxes yet. TaxSlayer Pro software is up to date and will walk you through the process. The exclusion is located on Schedule 1, Line 7 of Form 1040.  

For more information, read 2020 Unemployment Compensation Exclusion 

What if my client has already filed their 2021 return and did not take the exclusion? 

If you have already filed a return for your client, the IRS will refigure their taxes beginning this spring. There is most likely no need to file an amended return for your clients who need to take the exclusion. If your client overpaid on their taxes, they will either receive an additional refund or the amount will be applied to what they owed. The IRS will send any additional refund directly to your clients. They have begun correcting returns and the first payments should be sent out this weekend.

The IRS will complete these recalculations in two phases. First, they will work on single and married taxpayers who qualified for the $10,200 exclusion. Then they will work on returns for taxpayers who filed married filing jointly and who are eligible for the $20,400 exclusion. 

For more information, read this IRS press release. 

What if the new exclusion qualifies my client for an additional tax credit? 

If your client qualifies for an additional tax credit due to the exclusion, you will need to file an amendment for them. If your client already claimed the credit but needs to adjust the amount based on the exclusion, the IRS will calculate this. But if your client did not claim the credit or deduction and now qualifies, they must file an amendment to claim the tax break. 

How did the second stimulus bill impact unemployment compensation and taxes? 

The second stimulus bill extended and modified some of the unemployment benefits covered under the CARES Act. Whereas the CARES Act granted an extra $600 per week of federal unemployment benefits on top of regular state unemployment payments, the second stimulus bill continues the additional federal benefits but at a lower $300 per week.  

It also extends unemployment eligibility and the The Pandemic Unemployment Assistance program, so many who would have lost their benefits once the original extension expired can continue to collect payments for an additional 11 weeks. 

Unemployment benefits received under the second stimulus package will be taxed exactly the same as normal unemployment compensation (see below). Because this bill only applies to weeks of unemployment that began after December 26, 2020, most of these benefits will apply to your clients’ 2021 income and not their 2020 income. 

How is unemployment compensation taxed?   

The federal government taxes unemployment income like regular wages. However, unemployment income is exempt from Social Security and Medicare taxes.   

Most states also tax unemployment wages with some exceptions. For example, California, Montana, New Jersey, Pennsylvania, and Virginia do not tax unemployment.   

Your client should receive Form 1099-G from their state reporting their total unemployment compensation for 2020. Help them report this income on Schedule 1 of their 1040.   

How can my client reduce what they owe on their unemployment?   

Help your client check their withholding on their unemployment compensation. To avoid a large amount due on their taxes, have them withhold income taxes just like they would from their regular wages. They will need to fill out Form W-4V, Voluntary Withholding. The maximum amount they can withhold is 10%.   

Specific benefits that you can help them fill out Form W-4V for include:  

  • Benefits paid by a state from the Federal Unemployment Trust Fund   
  • Railroad unemployment compensation    
  • Disability benefits paid instead of unemployment   
  • Trade allowances made by the Trade Act of 1974   
  • Unemployment that falls under the Disaster Relief and Emergency Assistance Act of 1974  
  • Unemployment that falls under the Airline Deregulation Act of 1978 Program