Many government benefits are garnered tax free by the recipient. But that is not the case for all of them. Several of the most common government benefits claimed by many Americans – unemployment, Social Security, and disability – may be taxable, depending on the circumstances. Understanding and keeping track of how much of your government benefits can be taxed is key to eliminating unpleasant surprises when it’s time to file your taxes.
As with many things in the tax code, the first impression is that of complexity. But taken a step at a time, it’s possible to get a good approximation of how much is taxable.
Here are a few things to keep in mind if you’ve received unemployment benefits over the course of the past year.
1. Unemployment Benefits Are Taxable
Congress began a partial taxation on unemployment in 1979 and subjected all unemployment benefits to federal taxation in 1987. State unemployment payments had not been taxed from 1938 until the change in 1979.
In 2009, thanks to The American Recovery and Reinvestment Act, the first $2,400 of unemployment payments were exempt from federal tax. However, this benefit lasted for only one year, and since 2010, all unemployment benefits are taxable as ordinary income. At the end of the year, you should receive Form 1099-G with the amount of benefits you received, which you need to report on your tax return.
2. Opt for Voluntary Tax Withholding
You can avoid a big tax bill at the end of the year by filling out Form W-4V, which is a voluntary tax withholding request form. In doing so, the Federal Government withholds 10% of your unemployment compensation, much as a regular employer would.
You can also request federal income tax to be withheld from your Social Security benefits, Social Security equivalent Tier 1 railroad retirement benefits, Commodity Credit Corporation loans, or certain crop disaster payments under the Agricultural Act of 1949 or under Title II of the Disaster Assistance Act of 1988. In these cases, you may choose 7%, 10%, 15%, or 25% withholding.
Unemployment benefits are usually less than you would normally receive in wages, and that can create a false sense of security about how much tax you might owe. But if you are unemployed for weeks, the unemployment income mounts up. It is advisable to have taxes withheld from your unemployment. Fill out Form W-4V and send it to the office that handles your unemployment payments. For unemployment benefits, 10% is the only amount you can have withheld.
3. Factor in Additional Money Received
Any severance payments or money you received from unused sick days or vacation time is considered to be taxable income as well. More importantly, your employer may not have withheld taxes from these sums. It’s another reason to opt for withholding on your unemployment, or make estimated tax payments.
It is not at all unusual for people who receive Social Security payments to have other sources of income, such as a pension or annuity, a part-time job, investment income, or, for the semiretired, a small business. The effect of this additional income may be that some of your Social Security benefits are taxable.
According to the IRS, if Social Security is your only income, it is unlikely to be taxable. However, if you received other income during the year, some of your Social Security benefits may be taxable. Here’s how to approximate what portion of Social Security would be taxable.
1. Determine Your “Base Rate”
The base rate for your filing status helps determine what portion of your Social Security benefits are taxable. The base rates for the 2017 tax year are as follows:
- $32,000 for married couples who file jointly
- $25,000 for single filers, head of household, or qualifying widow/widower with a dependent child, or if you are married and filing separately but did not live with your spouse during the year
- $0 for married persons who file separately and lived together at any time during the year
2. Do the Math
If your “combined income” is more than the base rate for your filing status, a portion of your Social Security will be taxable, but not more than 85% of your benefits. The Social Security Administration suggests this formula for finding your “combined income“:
- Your adjusted gross income (without Social Security benefits)
- + Nontaxable interest
- + 1/2 of your Social Security benefits
If the total is less than your base rate for your filing status, your social security benefits are not taxable. If the total is more than your base rate, some benefits are taxable. The exact amount depends on your specific tax situation.
As an example, consider this scenario for Claudia and Devon, who file married filing jointly. Both receive Social Security benefits. Claudia received $9,000 in Social Security benefits, while Devon received $20,000. Their investments produce an income of $8,000 plus $500 in tax-free interest, and Devon has a pension that paid him $14,000.
According to the SSA formula:
- AGI = 14,000 + 8,000 = $22,000
- Nontaxable interest = $500
- 1/2 SS benefits = ($9,000 + $20,000)/2 = $14,500
- Combined Income = $22,000 + $500 + $14,500 = $37,000
As a married couple filing jointly, their base rate is $32,000. Since the total, $37,000, is above that amount, some of their benefits are taxable.
Note that in calculating “combined income” (called “provisional income” by some commentators), tax-exempt interest is added in. Tax-exempt interest is frequently from municipal bonds. Although the interest is not taxed on the federal return, it can increase the amount of your Social Security benefits that is taxable. That is a sometimes-unexpected side-effect of tax-free income.
3. Social Security Tax Limits
You can never be taxed on more than 85% of your Social Security benefits. Another way to say it is that 15% of your Social Security benefits are tax-free. To calculate exactly how much tax you can expect to pay, fill out Worksheet 1 in IRS Publication 915.
- Individuals: If your total combined income (as figured from Worksheet 1) is between $25,000 and $34,000, you generally pay income tax on up to 50% of your Social Security benefits. If your total combined income is greater than $34,000, you may have to pay tax on up to 85% of your Social Security benefits.
- Married Couples Filing Jointly: If your total combined income (as figured from Worksheet 1) is between $32,000 and $44,000, you generally pay income tax on up to 50% of your Social Security benefits. If your total combined income is above $44,000, you may have to pay tax on up to 85% of your Social Security benefits.
- Married Couples Filing Separately (Who Also Lived Together): You likely must pay tax on your Social Security benefits no matter what.
Disability payments can cause confusion during tax time. If you are receiving disability through the Federal Government, you must use the same rules as those for Social Security to determine whether they are taxable. However, if you participated in a disability insurance plan through your employer, you may be taxed on the proceeds.
Premiums vs. Payouts
The basic distinction with the taxability of disability insurance is whether the payments were made by your employer or by you. If your employer provided disability insurance as a fringe benefit at no cost to you, then the disability payments you receive are taxable. However, if you purchased disability insurance and paid the premiums, then the benefits you receive are not taxable income to you.
Assistance That Is Never Taxed
There are many kinds of government benefits that are never taxed. You should not include amounts for assistance in these categories in your income for tax purposes:
- Welfare or other public assistance based on need
- Work training payments, as long as they do not exceed what you would have received in welfare payments
- Food stamps or other nutrition assistance programs, such as elderly assistance, or women, infants, and children programs
- Disability rehabilitation training and assistance due to your disability, such as transportation
- Disaster relief grants, disaster relief payments, or disaster mitigation payments
- Mortgage assistance programs
- Replacement housing payments or relocation payments
- Winter energy bill reductions
- Medicare parts A or B benefits
- Veterans’ benefits, such as medical care, disability payments, education, or death gratuities
- Workers’ compensation benefits if paid under a workers’ compensation act
If you are the recipient of government benefits, you would be well advised to determine which are taxable and which are not. While the amount of information related to the taxability of government benefits may seem overwhelming, you would do well to educate yourself on the subject. Come tax time, you don’t want to suddenly discover that you have a large tax bill.
More importantly, you do not want to neglect to declare certain taxable disability income, and have your return audited for that omission (and get an even bigger tax bill because of penalties and interest).
Did you receive any government benefits this year?