Does unemployment qualify for earned income credit

The 2020 tax season is officially underway, and the millions of Americans who collected unemployment benefits last year due to the coronavirus pandemic may be in for a surprise.

That unemployment income is taxable, and if you didn't have money set aside or withheld for those taxes, it could reduce your refund or even lead to a bill.

This might be particularly unexpected for independent contractors and self-employed people who normally aren't eligible for state benefits but may have received Pandemic Unemployment Assistance through the CARES Act.

"There are going to be a lot of people this year that have unemployment insurance and they do not normally receive unemployment insurance benefits," said Elaine Maag, a principal research associate at the Urban-Brookings Tax Policy Center. "So it will be something new that they have to pay attention to."

Differences in state and federal treatment

If you had any unemployment income last year, it is subject to taxes and needs to be reported on your 2020 income tax return. In January, those who had unemployment income should have received a Form 1099-G that spells out the amount of money paid out during the year.

Federal income taxes apply to these benefits — whether it's state unemployment insurance or the pandemic unemployment compensation disbursed under the CARES Act.

The catch is that withholding the appropriate amount of income tax is voluntary. You can opt to have a flat 10% of your benefits withheld to cover the tax liability.

In order to do this, you'd have to file Form W-V4 with the state agency administering your unemployment.

You can also choose to make quarterly estimated tax payments to the IRS.

Uncle Sam isn't the only entity seeking a slice of your unemployment income. Most states will tax these benefits, too.

A handful of states — Alabama, California, Montana, New Jersey, Pennsylvania and Virginia — don't tax these payments. Indiana and Wisconsin offer a partial exclusion of unemployment income, according to Andy Phillips, director at the Tax Institute at H&R Block.

"Some states have withholding, and others require it in order to alleviate surprises when tax time comes around," said Jared Walczak, vice president of state projects at the Tax Foundation.

Though it's too late to head off the taxes you might owe for 2020, individuals who wrap up their returns early can at least plan to pay the amount owed by April 15 — the due date for tax returns and liabilities owed.

"You don't have to make a payment until April 15, but it's better to know in late January or early February that you have to come up with the dollar amount by then," said Phillips at the Tax Institute at H&R Block.

Unemployment and tax credits

Families who received unemployment income during 2020 should also be on the lookout for two key credits as they file their taxes: the earned income tax credit and the child tax credit.

Both credits add up to significant dollars — the earned income tax credit is worth up to $6,600 for a low-income household with three or more qualifying kids. And, the refundable portion of the child tax credit is worth up to $1,400 per qualifying child.

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The catch? While unemployment benefits are taxable, they aren't considered earned income.

Under normal circumstances, receiving unemployment would result in a reduction of both credits when you file your tax return.

Lawmakers fixed this problem in the year-end Covid relief act. This year, when you file your 2020 taxes, you'll have the option of using your 2019 income to calculate eligibility for the credit.

"If you went from being a wage earner to applying for unemployment, you can be affected," said Phillips. "Using your 2019 earned income just for figuring the amount of credits can be a huge benefit for taxpayers."

Many low- and moderate-income households no doubt were assisted greatly by enhanced federal Unemployment Insurance benefits that they received earlier this year and would be thrilled to receive a second round—if Congress and President Trump ever agree on a new pandemic relief bill. But for many jobless workers and their families, those payments come with a catch: They may result in smaller refunds from tax credits such as the earned income tax credit (EITC), next spring.

Tax Treatment of Unemployment Benefits

The problem: Unemployment Insurance (UI) benefits are taxable income but do not count as “earnings”. That means these benefits can lower, but not raise, the EITC, potentially leaving some low-income families with an unwelcome surprise at tax time. People will owe income tax on UI benefits, because they may not have had any income tax withheld when their UI benefits were received. For many lower-income families, that will mean part of those UI benefits will be clawed back in the form of a reduced EITC. That’s a special problem since research shows low- and moderate-income families plan for that annual tax refund, thoughtfully allocating it in advance towards paying past-due bills and laying the foundation for future savings.

On net, many families will receive more government support from the combined enhanced UI benefits and a smaller EITC than from what they anticipated their EITC would be. But losing part of their refundable credit next spring will diminish the value of this year’s jobless benefits for many recipients.

The IRS delivers refundable credits—payments in excess of taxes owed—through a refund during tax-filing season. But a possible problem is caused by the EITC’s complicated eligibility rules and payment formula that includes both a phase-in and a phase-out for the credit amount. Starting from zero, the amount of EITC that a taxpayer can claim increases with each dollar earned (wages, salaries, and income from self-employment count) until it hits a maximum amount. As earnings continue to increase, people receive the maximum amount for a given range of income. Then the EITC that can be claimed begins to decline as earnings rise further until it disappears entirely. (My colleague, Len Burman, has a plan to eliminate this phase-out.) 

The way the phase-out process works is tricky. Would-be recipients with income in the phase-out range essentially calculate the credit twice—first based on their earnings, such as wages, and again based on their Adjusted Gross Income (AGI) that includes unemployment benefits. If their AGI is higher than their earnings, they get the lesser amount. This means that receiving UI benefits can decrease the EITC, but cannot increase it.

How the EITC Responds to Lower Earnings

A reduction in earnings can affect the amount of EITC that a taxpayer can claim in three ways: It can increase the credit if a family otherwise would have earned too much to receive a payment or if earnings would have been in the phaseout range (Figure 1); it can reduce the credit by shifting a family from eligibility for the maximum credit to a smaller credit amount if the lower earnings are in the phase-in range (Figure 2); or it can eliminate the EITC entirely if a family loses all wage earnings (Figure 3).

During the Great Recession that began in 2008, more people saw their EITCs increase (as portrayed in Figure 1) than drop (as shown in Figures 2 and 3). But this current recession could show a very different effect: Jobless workers already have received almost $440 billion in UI benefits, more than three times as much as was received in all of 2009. And these UI benefits certainly have been critical for many workers.

But unlike other types of aid delivered in the wake of the coronavirus, UI might reduce the EITC for families who continue to struggle. To be clear, for these families net annual income may go up in 2020 compared to 2019 thanks to the enhanced UI benefits. But these families may not be getting their expected EITC refunds next spring, potentially dealing them an unexpected financial blow.

Recipients could have their refunds reduced further if they haven’t had taxes withheld on UI benefits: recipients have the option of having income tax withheld from their UI check at a 10-percent rate. But not everyone makes this choice, and that also may make for a negative surprise at tax time.

Congress could fix the problem by allowing families to choose whether to include jobless benefits in AGI for purposes of calculating the EITC. Rather than calculating the credit by taking the lesser of earnings or AGI, the 2020 tax form could direct families to use whichever measure yields the greater credit. Others have suggested simply choosing the larger of a family’s EITC from 2019 or 2020. That could also work, but this approach ignores the complicating factor that families change from year to year and along with them so do tax filing units.

In all likelihood, many families still will be hurting when they file their 2020 income tax returns next spring. Congress could legislate a new approach that would allow families to maintain a source of income they’ve come to rely on.