Government benefits such as unemployment, Social Security, and disability are part of a social safety net – a network of programs aimed at helping protect Americans from poverty and financial hardship. When you lose a job, need additional income during retirement, or become disabled and unable to work before reaching retirement age, these programs can provide a modest income to keep you on your feet.
Because these programs are designed to help people weather financial difficulties, it often surprises recipients to learn that these government benefits may be taxable income, depending on your circumstances. As with many things in the tax code, understanding how much of your government benefits are taxable is complex. Here’s what you need to know.
Congress began partially taxing unemployment in 1979 and subjected all unemployment benefits to federal taxation in 1987. In 2009, thanks to The American Recovery and Reinvestment Act, the first $2,400 of unemployment payments were exempt from federal tax in the United States. However, this tax benefit lasted for only one year, and since 2010, the Internal Revenue Service (IRS) taxes all unemployment benefits as ordinary income.
At the end of the year, you should receive IRS Form 1099-G with the amount of benefits you received, which you need to report on your tax return. Here’s how to prepare for potential taxes on your unemployment benefits.
Opt for Voluntary Income Tax Withholding
You can avoid a big federal tax bill at the end of the year by filling out Form W-4V, which is a voluntary tax withholding request form. By filling out the form, you authorize the federal government to withhold 10% of your unemployment compensation, much as an employer would withhold income taxes from an employee’s paycheck.
You can also use Form W-4V to request that federal income tax be withheld from your Social Security benefits, Social Security equivalent Tier 1 railroad retirement benefits, Commodity Credit Corporation loans, certain crop disaster payments under the Agricultural Act of 1949 or under Title II of the Disaster Assistance Act of 1988, and dividends and other distributions from Alaska Native Corporations. In these cases, you may choose 7%, 10%, 12%, or 22% withholding.
Unemployment benefits are usually less than you would normally receive in wages, so if you don’t have an emergency fund and need to live off of unemployment while you look for a new job, it’s tempting to skip the withholding and collect a bigger check.
However, if you’re unemployed for weeks or months, even modest unemployment benefits add up, so you should always request that taxes be withheld from your benefits. Fill out Form W-4V and send it to the office that handles your unemployment payments.
Pro tip: By using tax preparation software from a company like H&R Block, you’ll have confidence you’re getting every available tax deduction and minimizing your tax liability.
Factor In Additional Money Received
Your taxable income also includes any severance payments or money you received from unused sick days or vacation time. Your former employer may withhold taxes on these amounts, or they might not. If they don’t withhold taxes, it’s doubly important to opt for withholding on your unemployment benefits or make estimated tax payments.
It is not at all unusual for retirees who receive Supplemental Security Income (SSI) payments to have other sources of income, such as a pension or annuity, retirement plan distributions, a part-time job, investment income, or even a small business. In most cases, having additional income will cause at least part of your Social Security benefits to be taxable.
If Social Security is your only income, your benefits likely aren’t taxable. However, if you received other income during the year, up to 85% of your Social Security benefits may be counted as taxable income. Here’s how to determine what portion of your Social Security income is taxable.
Determine Your Base Rate
The filing status you choose when preparing your tax return determines what portion of your Social Security benefits are taxable. For the 2020 tax year, the amounts are as follows:
- Single or Head of Household: If your combined income is between $25,000 and $34,000, up to 50% of your benefits may be taxable. If your combined income is more than $34,000, up to 85% of your benefits may be taxable.
- Married Filing Jointly: If you and your spouse have a combined income between $32,000 and $44,000, up to 50% of your benefits may be taxable.
- Married Filing Separately: If you are married and file a return separately from your spouse, you will most likely have to pay taxes on your benefits.
Do the Math
For these purposes, your “combined income” is your adjusted gross income (Line 11 of your Form 1040 tax form) without Social Security benefits, plus nontaxable interest income, plus half of your Social Security benefits.
If the total is less than the amounts shown above, your Social Security benefits are not taxable. If the total is more than the amounts shown above, some of your benefits are taxable. The exact amount depends on your specific tax situation.
As an example, consider this scenario for Claudia and Devon, who are married and file jointly. Claudia received $9,000 in Social Security benefits for the tax year, while Devon received $20,000. Their investments produced an income of $8,000, plus $500 in tax-free interest, and Devon has a pension that paid him $14,000. Here’s how they would calculate their combined income:
- Adjusted Gross Income (AGI): $14,000 + $8,000 = $22,000
- Nontaxable Interest: $500
- Half of Social Security Benefits: $9,000 + $20,000 = $29,000 ÷ 2 = $14,500
- Combined Income: $22,000 + $500 + $14,500 = $37,000
As a married couple filing jointly, their combined income of $37,000 is more than $33,000, so up to 50% of their benefits may be taxable.
Note that tax-exempt interest was included in calculating this combined income. Tax-exempt interest frequently comes from municipal bonds. Although this interest isn’t taxed on your federal return, it can increase the amount of your Social Security benefits that are taxable – a sometimes-unexpected side effect of tax-free income.
Social Security Tax Limits
You can never be taxed on more than 85% of your Social Security benefits. In other words, 15% of your Social Security benefits are always tax-free. To calculate exactly how much tax you can expect to pay, fill out Worksheet 1 in IRS Publication 915.
Disability payments can cause confusion during tax time. If you receive disability through the federal government, you must follow the same rules as those for Social Security to determine whether these payments are taxable. However, if you participated in a disability insurance plan through your employer, you may be taxed on the proceeds.
The basic distinction with the taxability of disability insurance is whether you or your employer paid the premiums. 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.
Assistance That Is Never Taxed
There are many kinds of government benefits that are never taxed. Assistance in these categories should not be included in your income for federal income tax purposes:
- Welfare or other public assistance based on need
- Work training payments, as long as they don’t exceed what you would have received in welfare payments
- Supplemental Nutrition Assistance Program (SNAP) benefits (formerly called food stamps) or other nutrition assistance programs, such as elderly assistance or Women, Infants, and Children (WIC) benefits
- Disability benefits, rehabilitation training and assistance due to your disability, such as transportation
- Disaster relief, including disaster relief grants, disaster relief payments, or disaster mitigation payments
- Mortgage assistance programs
- Replacement housing payments or relocation payments
- Energy bill reductions for winter heating or summer cooling
- Medicare Parts A and B benefits
- Veterans’ benefits, such as health care, disability payments, education, child care assistance, death gratuities, and bonuses from a state or local government for service in a combat zone
- Workers’ compensation benefits if paid under a workers’ compensation act
If you receive government benefits, take some time to determine which are taxable and which aren’t. While the calculations may seem confusing, getting educated on the subject now will save you from an unwelcome surprise at tax time when you suddenly discover you have a hefty tax bill.
Also, knowing which benefits you must report as taxable income on your tax return can help you avoid failing to report that income and having your tax return audited. If that happens, you’ll wind up with an even larger tax bill because of penalties and interest.