Updated: Jan 12, 2021
Unemployment benefits are taxable income, and not everyone knows that, which could lead to some unpleasant surprises this tax season.
Unemployment benefits are taxable income, and not everyone knows that, which could lead to some unpleasant surprises this tax season. Axios has a piece addressing the fact that millions of people got unemployment benefits, and many don’t realize they owe taxes on it. The report calls it a “quirk” that income is taxed as income.
““In the case of a taxpayer determined by the Secretary to be affected by a federally declared disaster … the Secretary may specify a period of up to 1 year that may be disregarded in determining … the amount of any interest, penalty, additional amount, or addition to the tax for periods after such date".
It’s not a “quirk,” as my AEI colleague Kyle Pomerleau explains: “It is an application of the simple principle that the income tax system should tax all forms of income neutrally.”
Liberals have argued that all the benefits should be retroactively made tax-free, in part, because people budget in anticipation of large tax refunds. The interaction of unemployment benefits and the Earned Income Tax Credit is extra complicated, as the American Prospect and Pomerleau both point out.
There are big debates about what Congress should do here, on EITC specifically or taxability of unemployment benefits in 2020 more broadly, but there’s a narrower problem here, and Congress isn’t needed to solve it.
Anyone who failed to pay taxes on their unemployment during the pandemic should be exempt from all penalties and interest.
The $1,200 “stimulus” checks were tax-free, but the extra unemployment benefits weren’t. There is a logic to that, perhaps, but it’s not obvious to the average recipient, who couldn’t be blamed if he or she thought it was as simple as COVID aid is untaxed.
The underlying problem is this: The average person isn’t in the habit of setting aside a portion of her income in order to pay taxes at the end of the year. The average person certainly isn’t used to paying estimated taxes quarterly. If you’ve been living off salary and wages your whole life, then your boss has been paying your taxes for you by taking some out of each paycheck through withholding, and all you do is file and see if you get a big chunk of it back.
Yes, many people had withholding taken from their unemployment benefits, but it’s not automatic as with ordinary income, and it’s typically withheld at 10%, which is well below the marginal rate for a decent minority of taxpayers. The result is that lots of people who should have been paying quarterly taxes on their unemployment income weren’t.
Maybe this is a tiny number of people, but maybe it’s tens of thousands of people. Given the extraordinary nature of 2020, and the complexity of the year, Treasury Secretary Steve Mnuchin should consider using his emergency powers to waive all penalties and interest on taxes paid on unemployment income in 2020. If Janet Yellen is confirmed as Mnuchin's successor, she could take action if Mnuchin does not.
Mnuchin and his successor have such authority, it seems. Here’s the federal law: “In the case of a taxpayer determined by the Secretary to be affected by a federally declared disaster … the Secretary may specify a period of up to 1 year that may be disregarded in determining … the amount of any interest, penalty, additional amount, or addition to the tax for periods after such date.”