The Potential Tax Trap of Unemployment Compensation

Many of us are dealing with the unfortunate reality of unemployment, and the safety net of unemployment compensation. Fortunately, the CARES Act provided for an enhanced unemployment benefit, with an additional $600 per week. But hidden in this safety net is a potential tax trap.

Unemployment compensation is in theory a replacement, or partial replacement, for your regular compensation. It is subject to full federal income taxation, and in Mississippi and most states, it is subject to state income tax. In my observations, more often than not, no federal or state income tax is withheld on these unemployment benefits.

The trap is to replace a salary, that should have had adequate federal and state taxes withheld, with unemployment compensation with no such withholding. So you could get to the end of the year and have a nasty tax surprise, and owe hundreds, or this year could be thousands of dollars of income taxes with your 2020 tax return.

So the best answer is to have federal and state taxes withheld on your unemployment compensation. The second choice would be to put 17 to 27 percent of the total benefits aside in a savings account to have a place to draw from to pay the 2020 taxes next Spring.