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Taxes and Unemployment; How to Avoid Surprises and Owe Less Tax

Did you know that unemployment benefits are subject to income tax? It comes as a surprise to many people. But don’t fret too much because there are also special tax breaks for the unemployed, such as job search deductions and the earned income credit.

Taxes and Unemployment; How to Avoid Surprises and Owe Less TaxThere aren’t many – if any – perks of being unemployed. We all know that.

But if you do lose your job, it may be possible to lean on the government for awhile and survive on unemployment compensation.

These government-funded unemployment benefits can be very helpful, but what many people forget is that this supposed “free ride” isn’t actually very free.

Unemployment taxes

Many people are surprised to learn that any unemployment compensation you receive from the government is, in fact, taxable.

That’s right: When you submit your yearly tax return in April, you’ll have to include that money you received for being unemployed as part of your income. It may sound a little backwards, but the government still considers that your income.

You can avoid a surprise tax bill in April if you decide to have taxes withheld from your unemployment check (exactly like you would if you were employed by filling out a W-4).

You’ll just need to fill out a W-4V form and 7, 10, 20, or 25 percent (your choice based on your overall income) will automatically be deducted from your unemployment check. Remember that you’ll still have to include these amounts in your tax return to calculate your exact tax bill, but the initial withholding can help the sticker shock on your overall tax bill.

Another point to remember is that ALL unemployment benefits are taxable for tax years after 2009.

Early retirement plan distributions

Many people who become unemployed will draw from other sources to fund their living expenses until they find work again.

Although it is risky and not recommended, many will draw from their retirement accounts when they’re without a job. This is a last resort, and we recommend going through alternative sources first (like seeking government aid, as mentioned above), but if this is 100 percent necessary, here’s how you would handle this situation:

If you withdraw money from your Individual Retirement Account (IRA) or 401(k), you will be subject to tax penalties for early withdrawal (assuming you’re not at least 59 1/2 years old).

For both accounts, early withdrawals are taxable and an additional 10 percent tax is collected on these withdrawals. The government encourages people to leave their retirement accounts untapped until they’re actually at retirement age, which is why they levy such high taxes on these accounts.

One major exception to this rule is our friend, the Roth IRA. You actually can withdraw funds from your Roth IRA, but there is one catch: You can only withdraw your contributions without penalty. The earnings on your Roth IRA cannot be withdrawn before age 59 1/2 without penalty.

Remember: these are high-level rules, and there are several exceptions related to disability and transfer of funds to other accounts or beneficiaries, so double check with the IRS if you have any questions.

Tax breaks for unemployed

Earned Income Credit. Many people who are unemployed become eligible for the Earned Income Credit because their income drops so significantly. This tax credit was designed for those who earn small amounts of income.

To qualify for 2014, your Adjusted Gross Income (AGI) must be less than:

  • $46,227 ($51,567 married filing jointly) with three or more qualifying children
  • $43,038 ($48,378 married filing jointly) with two qualifying children
  • $37,870 ($43,210 married filing jointly) with one qualifying child
  • $14,340 ($19,680 married filing jointly) with no qualifying children

The great thing about this credit is that it a “refundable” credit – meaning even if you owe zero tax, you can still receive a refund.

Job Search Expenses. Anyone who is job searching is eligible to deduct certain job search expenses. But be warned – you must itemize your deductions to claim these expenses AND they (in addition to other miscellaneous itemized deductions) must exceed 2 percent of your AGI.

That may seem daunting, but it’s a good start if you just keep track of these job search expenses. Keep records of these qualifying expenses:

  • Employment placement organization fees
  • Resume printing
  • Phone calls
  • Travel and transportation
  • Moving expenses

For a more detailed explanation of job search deductions and/or itemized deductions, check out these Money Under 30 articles:

Questions? Have you had to deal with unemployment taxes recently?

Published or updated on November 5, 2012

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About Amber Gilstrap

Amber is a twenty-something CPA from Kansas City, Missouri who loves writing, working out, and---of course---finding fresh ideas for saving money. Follow her on twitter @amberinks.


We invite readers to respond with questions or comments. Comments may be held for moderation and will be published according to our comment policy. Comments are the opinions of their authors; they do not represent the views or opinions of Money Under 30.

  1. Robert says:

    I have no complaint with the tax deduction. What matters is the government is providing support that other countries are not providing to their unemployed citizens. Although it is a priviledge, I agree on some of its limitations.

  2. Monica says:

    I can’t believe I’m defending our crazy tax code, but: Maybe the government asking for taxes later could be a bit of a push to get that productive work. A partial loan of sorts. After all, it’d probably be more expensive to police a productive work requirement….

  3. peth says:

    I am constantly amazed(in a bad way) by how the government polices our money. Since they think it’s theirs anyway they make laws that hand it straight to them. Imagine me giving a homeless person a meal and asking for a part of it back? I should at least ask him to do an hour of productive work before I feed him……..

  4. Drew says:

    This is exactly what a 6 month emergency fund is for. If you lose your job, you know that you can still pay all of your bills for 6 months without going on unemployment. That should be plenty of time to find a new job. There’s also a higher degree of motivation to find a job quickly when it’s your money you are spending as opposed to “free money from someone else”.

    • Alex says:

      I disagree. Even with 6 months of emergency fund, and most of our living expenses fitting in one income, my husband and I are taking unemployment after he got laid off. He paid into the system with payroll taxes didn’t he? Why shouldn’t he take it out when we need it? It’s just like social security in that way. I think we would be crazy if we didn’t take the unemployment money. What if it takes longer than 6 months to find full-time work and we go through the emergency fund? That’s why we are taking unemployment…in this economy, it could take 1 month or more than 1 year to find new work. Plus, you never know what emergency might come up where you need that extra money.

      • Aram Durphy says:

        Yes, unemployment is essentially an insurance fund the government compels employers to pay into. It makes sense to collect your insurance when the event insured against happens.

        Also, the 6 month emergency fund is a very good idea for just about everyone. One never knows how long a job search will last, or what other expenses will crop up. And remember, you don’t want your emergency fund in the stock market, or in other volatile investments, because you might have to withdraw during a market downswing.

  5. Oh man! We are talking about taxes already?

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