Why Unemployment Benefits Are Taxable – And What Happens If You Don’t Withhold Taxes

When times get tough and you lose your job, unemployment benefits can be a financial

lifesaver. These payments are designed to help individuals meet their basic needs while they search for new employment. However, many people are surprised to learn that unemployment benefits are considered taxable income by the federal government — and in some states as well. Massachusetts, Maine and New York for example are states that fully tax unemployment income.

So, why are these benefits taxed? And what happens if you don’t have taxes withheld from them?

Why Are Unemployment Benefits Taxable?

Unemployment compensation is treated like regular income by the IRS. That means when you receive it, it’s subject to federal income tax just like wages or salaries from a job. Here's why:

1. They Replace Wages: Unemployment benefits are meant to replace part of your

income. Since the income you earn from working is taxable, the income you receive from unemployment is too.

2. It's Considered Government Assistance, Not a Tax-Free Grant: These benefits are

part of a federal-state program designed to temporarily support individuals who have lost their jobs. They're not gifts — they’re still income in the eyes of the IRS.

3. Fairness and Revenue: Taxing unemployment income ensures consistency across

income sources and contributes to federal revenue, which helps sustain various

government programs.

Do All States Tax Unemployment Benefits?

Not necessarily. While the federal government always taxes unemployment benefits, some states do not. As of recent years, states like California, New Jersey, Oregon, Virginia and Pennsylvania exempt unemployment income from state taxes, while others tax it fully or partially.

It's important to check your own state's rules to understand your full tax obligations.

Are you unsure if unemployment is taxed in your state? We would be happy to help you to navigate this situation. We are available for consultations for this matter.

What Happens If You Don’t Withhold Taxes?

When you begin receiving unemployment, you typically have the option to have federal income taxes withheld from each payment — usually at a flat rate of 10%. However, if you don’t opt in for withholding, here’s what could happen:

1. You Might Owe Taxes at Filing Time: If you didn’t withhold any taxes during the year, you might face an unpleasant surprise when you file your return.

2. Penalties for Underpayment: Depending on how much you owe and your overall tax situation, you could also be hit with an underpayment penalty. The IRS expects taxes to be paid throughout the year — not just at tax time.

3. Impact on Refunds: If you typically receive a refund, the unpaid taxes on your

unemployment benefits could reduce or even eliminate it.

What Can You Do?

If you’re receiving unemployment benefits and didn’t elect to withhold taxes, you still have options:

● Make Estimated Tax Payments: You can submit payments directly to the IRS quarterly to avoid penalties. We are able to help you figure out these amounts!

● Adjust Withholding Elsewhere: If you’re working part-time or freelance, adjust tax

withholding from other income sources to cover the shortfall. Are you unsure if this route is appropriate for you? We can help to guide you.

● Plan Ahead: Meet with one of our reliable CPA’s to help project your tax liability so there are no surprises during tax time. Our experienced team would be happy to guide you through this financial situation.

Bottom Line

Unemployment benefits play a crucial role in helping people navigate tough transitions, but they come with tax implications that shouldn’t be overlooked. Both employees and employers have responsibilities in the process. While individuals must plan for tax obligations, employers should ensure they handle claims properly, pay into the system, and support their former employees as much as possible. To find more information about employers' role in unemployment click here.

Planning ahead and understanding everyone’s role can make the system work more effectively — and with fewer surprises come tax season.

Please feel free to share this with your relatives and friends and remember we are here to help our clients.

Terranova & Associates, LLC.

Thomas D. Terranova, Jr., CPA, PFS, CITP