The 2021 tax filing season was already destined to be unlike any other. Add in the fact that nearly a quarter of the labor force brought in income from unemployment benefits, and the picture gets even more complicated.
Unlike your $1,200 and $600 (or more) coronavirus stimulus checks, unemployment insurance (UI) is subject to federal and, in some cases, state income taxes. That’s true for the entire alphabet soup of CARES Act-backed joblessness programs — Pandemic Unemployment Assistance (PUA), Federal Pandemic Unemployment Compensation (FPUC) and Pandemic Emergency Unemployment Compensation (PEUC) — and your state benefits.
Adding another layer of complexity, you may have been enrolled in a combination of all of those programs, depending on where you live, what you did for a living and when you lost your job. And making matters worse, coronavirus-related job losses happened swiftly. Many consumers, cash-strapped and fretting about making ends meet, were understandably hard-pressed to start claiming jobless benefits, often before they were even aware that they should be withholding taxes.
That oversight could negatively impact your bottom line. In the worst of cases, you could also open yourself up to extra penalties or fees. But rest assured: Tax preparation experts say there’s several steps you can take to help reduce the amount you owe or even waive those fines altogether.
“For so many people, this was their first time ever getting unemployment, and so there’s a lot that they straight up didn’t know,” says Kathy Pickering, chief tax officer at H&R Block. “What we have seen right now is that, for the majority of people who are filing a tax return with unemployment income, they’re still getting a refund. It may not be as big as they have seen in prior years, but they’re still getting a refund.”
Here’s seven steps you should take to prevent fines and fees from eating away at your 2020 tax return if you drew unemployment benefits last year or were unaware that you should be withholding income taxes.
1. Know the penalties you might be up against — and the exceptions
Just because you didn’t withhold taxes on your unemployment benefits doesn’t always mean you’re going to be subject to a penalty, but it’s important to at least be aware.
Generally speaking, if you still owe more than 10 percent of your tax liability by April 15, you could see a charge worth 0.5 percent of the tax owed after the due date, for each month or part of a month the tax remains unpaid, up to 25 percent, according to the IRS.
You would also be charged some interest on that penalty. Those costs change every three months but generally hold between 3-3.25 percent (the Fed’s federal funds rate plus a 3 percent margin).
There are some exceptions and safe harbors: If the balance that you owe is less than $1,000 (after subtracting your eligible withholdings and credits), you would be exempt from the penalty.
The IRS also exempts individuals from the failure to pay penalty if they covered 100 percent of the tax shown on the return for the prior year.
If you were working for part of 2020, as many Americans were before the coronavirus pandemic, you might’ve already managed to pay at least 90 percent of the taxes you owe for the year.
“If you didn’t have money withheld from your unemployment [benefits], that alone is not necessarily a problem,” Pickering says. “Really, what the IRS is looking at is, have you been paying taxes throughout the year?”
Your tax liability might have also fallen in the year that you were unemployed, helping to reduce the amount you’re expected to cover.
“Chances are, the unemployment you received even with the enhanced amount that was provided by the federal government isn’t going to equal or exceed what you ordinarily would receive in wages,” says Henry Grzes, lead manager for tax practice and ethics at the American Institute of CPAs. “You would obviously have a tax liability, but it may not be as great as you might’ve had with the wages themselves.”
2. Understand how your unemployment income is taxed compared to regular wages
When you opt in to have taxes withheld on your unemployment benefits, the IRS will most of the time do so at a flat 10 percent rate. That can be used to cover all or part of your tax liability for the year. The federal income tax rate that you’re charged, as always, depends on how much income you brought in during any given tax year overall.
Whether it’s wages, unemployment benefits or lottery winnings, “those are all treated the same,” Steber says. “They’re taxable, they go on your tax return and you pay taxes on them.”
Unemployment benefits, however, are not considered regular earnings and wages from the IRS’s perspective, meaning they’re exempt from the 12.4 percent Old Age, Survivors and Disability Insurance (OASDI) tax.
But those are just federal taxes. At the state level, it gets a bit trickier and how much your unemployment income is taxed depends on where you live. For example, more than a dozen states — including New Jersey and California — do not place levies on your unemployment benefits. The rules are also changing all the time. Maryland, for example, just passed coronavirus-specific legislation that offers jobless Americans relief from state and local taxes on their unemployment income. Be sure to research tax rates specific to your area.
3. Think about credits that can help lower your total
Tax credits are going to be your best ally if you forgot to set a withholding on your unemployment benefits. Every dollar that you’re eligible for in a credit goes toward subtracting from the income taxes that you owe.
Be sure to research all of the credits for which you’re eligible, the main ones being the Earned Income Tax Credit (EITC), the Child Tax Credit (CTC) and the Child and Dependent Care Tax Credit (CDCTC). You might not also be aware, but you can find certain tax savings depending on how much mortgage or student loan interest you pay in a year, as well as other credits for education-related expenses.
There’s a potential downfall: You might not be eligible for as high of a credit amount, given that some credit eligibility is based on earnings, not income. But pay attention to special changes out of Washington. One such example: If you didn’t have enough earned income in 2020 to qualify for the EITC, you could use your 2019 tax return when you apply for the credit, potentially helping you get a better result.
Also making a big difference could be the Recovery Rebate Credit, a new tax opportunity specific to 2020 thanks to the first and second rounds of coronavirus stimulus checks. Americans can apply for the credit if they didn’t receive any or all of the amount for which they were eligible. For a family of four with child dependents, that credit could be as high as $5,800 if you never received any payment.
“Don’t let fear guide your decisions and if you really are stressed, which as so many people are right now, you can get the help to know you’re getting every dollar you deserve,” Pickering says.
4. Gather all relevant documents, and file as soon as possible
No one likes to be in trouble with the tax collector — a sentiment so widely shared that The Beatles wrote a song about it.
But don’t delay filing your return just because you’re worried about getting hit with a penalty or owing a balance. The failure to file penalty can be 10 times more expensive than the failure to pay penalty.
Gathering all of your documents, preparing your return and filing as soon as possible can help you know exactly what you’re up against and what steps you need to take to cover your fees or bill before the deadline.
“It’s not that everyone who had unemployment and didn’t have withholding is going to get a penalty,” says Mark Steber, senior vice president and chief tax officer at Jackson Hewitt. “If you do owe, you need to know how much that is and how much trouble you might have raising that money.”
Similar to how you would’ve received a W-2 from your employer, you should receive what’s called a “1099-G” representing all of your unemployment income from both federal and state sources. You could also receive multiple iterations of the form depending on how many unemployment programs you utilized. You should be able to either find those documents online or in the mail, the latter of which should’ve been postmarked by Jan 31.
As always, be careful to report all of your earnings sources in the year, whether that be from regular wages at a business, a firm that you started in the year or even from gig work or self-employment.
“Any time you’ve got missing income on your tax return, you can expect to hear from the IRS in the form of a letter,” Pickering says. “That could be something as simple as maybe you worked part time for a little while and forgot, or it was earlier in the year and you didn’t expect a W-2, or you thought you’d get a 1099-G in the mail, but you never saw it, so you went ahead and filed without it.”
5. If hit with a penalty, see whether you’re eligible for a waiver or certain exemptions
Even if you are hit with an underpayment penalty, there are certain ways to get around it.
For instance, the IRS says taxpayers won’t have to pay the penalty if they can show reasonable cause for the failure to pay on time.
Some examples of circumstances that qualify for a penalty waiver include a casualty, disaster or other unusual circumstance, according to the IRS. Retiring after reaching age 62, becoming disabled in the current or prior tax year also qualifies you for the penalty waiver, as does having a reasonable cause for not making the payment or being able to demonstrate that the underpayment was not due to willful neglect, the IRS states.
Even though the law doesn’t state that coronavirus-related unemployment ignorance qualifies, it’s worth a shot to ask if it would save you a significant chunk of change. You’ll also need official documents such as court or hospital records to back up your claims.
You can file for a waiver by filling out Part II for Form 2210.
“It’s always best practice to ask for forgiveness because this was a strange year,” Steber says. “The IRS isn’t going to look to apply these provisions to get you a bigger refund, a bigger break or a tax exemption that you didn’t know you’d get but you qualify for. It’s incumbent upon you to look for all the rules and all the benefits and all the opportunities.”
6. Make sure you get your questions answered
If your tax situation is more complicated this year than in the past, you might want to consider consulting with a tax professional. Finding out about an obscure tax credit or getting help applying for a penalty waiver could be the difference between owing or receiving thousands of extra dollars on your return.
Even if you want to avoid paying a tax professional and prefer DIY taxes, you should still consider reaching out to an expert or Certified Public Accountant (CPA) if you encounter any odd questions here or there.
“There’s all kinds of help, and it’s important for everyone to know that, so you don’t get into a situation where you’re missing out on benefits you could be taking advantage of or freaking out and not filing because it’s too complicated,” Pickering says.
7. Don’t repeat the same mistakes
Almost a year into the coronavirus crisis, the number of Americans claiming and applying for unemployment benefits is still historically elevated.
If you’re still on unemployment benefits, now’s the time to make sure you’re withholding taxes, so you don’t confront the same problems down the road.
“Your return for 2020, that’s history. Right now, let’s talk about 2021 and what we can do in the next eight or nine months to improve your situation, so that you don’t owe $1,000 with this return next year,” Grzes says.
How to cover the payment if you do end up owing money to the IRS
You’re not entirely out of options if you’ve taken these steps and still owe money to the IRS. The sooner you file, the better. If you filed your taxes right now, you’d have almost two months to adjust your expenses and save enough cash to cover the cost.
“If someone has never been in the situation where they’ve owed money to the IRS before, it’s natural to have that panic reaction,” Pickering says. “What’s really important for people to do is first understand how much they owe and then realize that they’ve got time to work out that plan and they’ve got lots of options for how to make those payments.”
If you can’t possibly find a way to come up with the cash, the IRS offers payment plans. These tend to be more flexible for your financial situation and often allow you to dish out whatever cost you can afford upfront. You may also want to consider borrowing from a family member or friend before dipping into your retirement account or utilizing a credit card.
“It’s a risk to be sure, and a higher certainty if you had a lot of unemployment, which you could’ve done between the expansion of the state benefits or the federal programs that extended benefits,” Steber says. He adds that 3 out of 4 taxpayers end up seeing a refund. “It may well be [that] you get a smaller refund, but the reality is, you don’t necessarily owe a penalty.”