Dave Carpenter | Dave Carpenter

Unemployment benefits are subject to federal taxes and are taxed in some states, too

March 6, 2009
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Some Americans are learning a jarring lesson about unemployment as they prepare their tax returns: Jobless benefits are taxed like income. That leaves many on the hook for hundreds or thousands of dollars, because the taxes aren't automatically withheld from benefit checks.

To make things worse, some people also are hit with a state unemployment tax bill.

The tax is no secret - unemployment benefits have been fully taxable for more than 20 years. But many complain that they aren't properly informed.

The economic stimulus program will temporarily ease that impact by eliminating federal income taxes on the first $2,400 of unemployment benefits received this year. It's a one-shot break, though, and the boost may last for just a few weeks.

The exclusion won't immediately help people who lost their jobs last year, like Eric Victorson of Issaquah, Wash. The 35-year-old business systems analyst was laid off in October, forcing him to get by on a $541-a-week unemployment check after making three times that from Microsoft Corp.

He didn't realize the tax jolt he'd get until this year. What would have been a $2,900 refund was whittled to $1,400.

Those seeking to minimize tax-time problems can request that income taxes be withheld from their unemployment checks or simply set money aside to make sure they can pay the taxes by April 15. But that may be difficult.

Inna Shaulskaya, a 29-year-old New Yorker who was laid off in November, learned about the taxes and signed up for withholding. But even with getting the maximum $405 a week for New York State, subtracting the taxes doesn't leave her enough to avoid tapping an emergency fund to pay her mortgage. Taxing unemployment benefits, she said, is "not logical whatsoever."

It hasn't always been this way. Unemployment compensation was tax-free until 1979, when the government made it partly taxable. The move came after some policy studies found tax-free paychecks reduced the incentive to find a job. Congress made benefits fully taxable in 1987.

The $787 billion economic stimulus package signed into law last month is the first time since then the tax has been even temporarily eased.

The 2009-only change wasn't enough for some, however.

"Taxing those seems like a really crazy practice to me," said US Representative Virginia Foxx, a North Carolina Republican, who is sponsoring a bill to eliminate all federal income taxes on unemployment benefits.

"It's like giving with one hand and taking with another. I just think it's unfair to tax the benefits of these people who are struggling to find work, particularly in a difficult economic time."

Foxx admits, however, that the chances of her measure passing in this environment are not strong.

Dave Carpenter is an Associated Press personal finance writer.

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