If receiving unemployment income is new to you, did you know that it’s taxable income?
Many people received unemployment income recently for the first time due to the pandemic. However, you may not realize that it’s considered taxable income by the IRS. Here are the steps you need to take to determine how much you should be paying now in income taxes and avoid a potential underpayment penalty.
Pay As You Go System
The United States tax system is a pay as you go system, meaning everyone is required to pay taxes on money as you earn it. When you file your tax return once a year, that’s when you figure out if you overpaid, underpaid or paid around the right amount during the prior year. If you didn’t pay enough taxes on income at the time you earned it, not only will you need to write a check to the IRS at tax time for the income taxes that you owe, but you may also be subject to an underpayment penalty too. This will increase the amount you need to pay at tax time, and nobody wants that to happen.
Income Tax Withholding
If you had taxes withheld from your unemployment check at the time it was sent to you then you may have had enough withheld. But it’s still a good idea to be sure to avoid any surprises come tax time. However, if you didn’t have taxes withheld from your unemployment check at the time it was sent to you, then it’s an even better idea to esimate what you will owe in taxes for the year. You’ll need to pay quarterly estimated taxes if you haven’t paid enough in taxes for the income you’ve received so far this year. Paying estimated taxes during the year you earn the money will prevent you from you needing to come up with a large sum of money at tax time and will also avoid a potential underpayment penalty on top of that.
How to Estimate Taxes Owed
There is a worksheet on the IRS website, www.irs.gov which can be used to estimate the amount of income taxes you may owe. To find the worksheet, search for “2020 Estimated Tax Worksheet” in the search function on the IRS home page or click on this link: https://www.irs.gov/pub/irs-pdf/f1040es.pdf . The worksheet is part of the IRS Form 1040-ES which has a lot of useful information in it about estimated taxes, how to calculate them, and how to pay them. The worksheet looks a little scary at first like all IRS forms do, but if you take it step by step it’s more manageable than you would think. And not everything on the form will apply to everyone so some lines on it may not apply to you and you can just skip them.
If You Are Now Employed
If you are now working again and you receive a paycheck from your employer, you can use an online tool on the IRS website called paycheck checkup. It can be found here: https://www.irs.gov/individuals/tax-withholding-estimator . It will let you know if you are having enough withheld from your paycheck to prevent an underpayment penalty or if you need your employer to withhold more taxes between now and the end of the year to avoid a potential underpayment penalty. Either way, it’s much better to know now if you are in good shape with the IRS when there is still time to make adjustments and plan around the extra expenses if needed.
Other Reasons to File Estimated Taxes
In addition to receiving unemployment income, there are other times when you may need to pay quarterly estimated taxes in order to prevent an underpayment penality. Any time you receive compensation from another person or business and they do not withhold income taxes from the payment, you may owe income taxes on the payment. If you receive income such as interest, dividends, alimony, self-employment income, capital gains, prizes and awards, you may have to make estimated tax payments. If you are in business for yourself, you generally need to make estimated tax payments. Estimated tax is used to pay not only income tax, but other taxes such as self-employment tax and alternative minimum tax.
Who Must Pay Estimated Taxes
Individuals, including sole proprietors, partners, and S corporation shareholders, generally have to make estimated tax payments if they expect to owe tax of $1,000 or more when their return is filed. Corporations generally have to make estimated tax payments if they expect to owe tax of $500 or more when their return is filed.
When Not to File Estimated Taxes
You don’t have to pay estimated tax for the current year if you meet all three of the following conditions:
- had no tax liability for the prior year
- were a U.S. citizen or resident for the whole year
- prior tax year covered a 12-month period
You had no tax liability for the prior year if your total tax was zero or you didn’t have to file an income tax return. For additional information on how to figure your estimated tax, refer to Publication 505, Tax Withholding and Estimated Tax.
As always, if you would like more information on this topic, please contact me.
Disclaimer: This article is provided for general information and illustrations purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult with a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Tricia Rosen, and all rights are reserved. Read the full disclaimer.