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What You Need to Know

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What You Need to Know

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If you received unemployment compensation during 2020, you may be worried about having to pay income tax on the amount you received when you file your taxes. Luckily, a recent law change introduced in the American Rescue Plan will allow many taxpayers to forgo paying income tax on unemployment compensation.

If you earned less than $150,000 in modified adjusted gross income, you can exclude up to $10,200 in unemployment compensation from your income. If you’re married and filing jointly, you can exclude up to $20,400.

Here’s everything you need to know about the IRS unemployment refunds, including what to do if you’ve already filed your taxes.

Recalculated taxes on 2020 unemployment benefits

IRS Unemployment Refunds: What You Need to Know - Recalculated taxes on 2020 unemployment benefits

During a normal year, unemployment benefits are taxed as regular income, which means you’ll need to pay income tax on any compensation you receive. In 2020, some unemployment recipients may have had the option to have income taxes taken out of their unemployment compensation upfront. States are typically required to offer income tax withholding at a rate of 10% for unemployment benefits.

However, other recipients received their full unemployment benefits without the option to pay income tax, especially if they received additional unemployment income through the CARES Act. Still, other recipients had the option to withhold income taxes but chose to receive the full amount of their benefit due to financial need. Without the recent legislation, these taxpayers would have potentially been on the hook for hundreds or even thousands of dollars in income tax.

As a result of changes introduced by the American Rescue Plan, Americans who have received unemployment compensation no longer have to pay income taxes on the first $10,200 in unemployment income. If you’re married and filing jointly, you don’t have to pay taxes on the first $20,400. If you received more than $10,200 in unemployment (or $20,400 filing jointly) you may still have to pay tax on any benefits you received that are above this amount.

Recalculated taxes on unemployment benefits represent a significant tax break for many Americans. According to the Century Foundation, approximately 40 million Americans received over $580 billion in unemployment insurance benefits. The new legislation means that the Americans who have been hardest hit by the pandemic will be able to keep more of their income in their bank accounts.

What to do if you haven’t filed your taxes yet

If you haven’t filed your 2020 taxes yet, there’s nothing extra you need to do in order to take advantage of the new law. For taxpayers who plan to file their taxes online using tax preparation software, all you need to do is respond to questions concerning your unemployment compensation when preparing your return. Tax preparation software has already been updated to reflect the change in the law.

If you file taxes with the help of a tax preparer, they can help you navigate the process. If you choose to file a paper return, you can access instructions and an updated worksheet on the IRS website.

If you didn’t pay any income tax on unemployment income in 2020, you won’t be responsible for these payments when you file your taxes.

What to do if you’ve already filed your taxes

IRS Unemployment Refunds: What You Need to Know - What to do if you've already filed your taxes

If you filed your taxes before the new law went into effect, don’t worry. Any overpayment will be refunded by the IRS. This refund may also be applied to other taxes owed. Unemployment refunds are scheduled to be processed in two separate waves.

The first wave will recalculate taxes owed by taxpayers who are eligible to exclude up to $10,200. The second wave will recalculate taxes owed by taxpayers who are married and filing jointly, as well as individuals with more complicated returns.

When to expect your unemployment refund

Refunds are expected to begin in May. Depending on whether you fall into the first or second wave, these payments will continue into the summer. If you filed your taxes electronically, you may receive an electronic refund deposited straight to your bank account. If you mailed a paper tax return, you may receive a physical check in the mail.

Should you file an amended return?

In most cases, it’s not necessary for taxpayers to file an amended return. The IRS will automatically recalculate the tax you owe and issue a refund if you overpaid your unemployment income tax.

However, there are a few cases where filing an amended return may make sense. The American Rescue Plan also adjusted the eligibility requirements for the Earned Income Tax Credit, which means that more taxpayers may qualify. If you didn’t originally qualify for the EITC but are now eligible to do so, you should consider filing an amended return.

What about state taxes?

State taxes on unemployment vary depending on where you live. Some states, like California, Montana, New Jersey, Pennsylvania, and Virginia, don’t charge income tax on unemployment benefits. Other states don’t charge any income tax.

If your state does charge income tax on unemployment benefits, they may offer similar tax breaks in line with the federal unemployment refunds. You should check for updates from your particular state before filing. Online tax preparation software or in-person tax preparers can also help if you have questions about your individual return.

What to do if you receive a refund

IRS Unemployment Refunds: What You Need to Know - What to do if you receive a refund

A hefty tax return can be a welcome windfall during uncertain financial times. If you do receive an unemployment refund from the IRS, here are some ways to put your money to work for you.

Build up your financial safety net

Many Americans’ finances have been devastated by the pandemic. Even workers who are eligible for unemployment benefits may still face financial uncertainty in the future. If you don’t already have a financial safety net built up, you should consider stashing away your refund in your savings account. Experts recommend saving somewhere between three and six months of living expenses in an emergency fund. If you’re not sure how much you should have saved up, MU30’s emergency fund calculator makes it easy to find out.

Pay down high-interest debt

If you’re carrying around a hefty debt burden, an unexpected windfall like an unemployment refund is a great opportunity to pay down debt and work towards becoming debt-free. You should consider using your refund to pay down high-interest debt like credit cards, auto loans, and personal loans.

Save for retirement

Not only is saving for retirement an investment in your future, but it also comes with some potential tax benefits. If you have access to an employer-sponsored retirement plan like a 401(k), you should try to contribute as much as you can in order to take advantage of your employer’s matching contributions. If you don’t have access to an employer-sponsored plan, you can contribute to a traditional or Roth IRA.

Summary

Thanks to the American Rescue Plan, many Americans who previously owed income tax on unemployment compensation no longer owe money to the IRS.

If you haven’t filed your tax return yet, you don’t need to take any extra steps in order to qualify for this tax refund. If you’ve already filed your taxes, the IRS will automatically recalculate the taxes that you owe and issue you a refund.

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