After you've lost your job and applied for unemployment benefits, you'll probably be grateful to start receiving the meager checks to which you're entitled under federal law. You'll be less than happy to realize that the IRS adds insult to the injury of unemployment by withholding taxes from your unemployment checks at the standard income tax rate. If your annualized unemployment benefit is $40,000, you'll receive just over $30,000 of that in cash. The rest will remain in the hands of the IRS until you file your taxes at the end of the tax year.
In past years, there was no exception to this unfortunate arrangement. The IRS simply taxed unemployment benefits as regular income and provided unemployed taxpayers with no means of recouping withheld funds. Of course, taxpayers could still hope for a refund after filing a proper tax return. However, high-earning job-seekers with no dependents or mortgage obligations could reasonably expect to lose the bulk of their withheld funds to the government.
The IRS recently updated its policy towards taxable unemployment benefits. While the bulk of such benefits are still taxed, it now permits taxpayers to deduct unemployment benefits worth up to $2,400 from their total calculations of taxable income. This isn't a huge improvement. However, it gives taxpayers who sit near the bottom of their tax brackets the chance to move into a bracket that may be taxed at a lower rate.
If you're one of these "marginal cases," this deduction may dramatically boost the size of your tax refund. Any increase to your refund may be mitigated by your state revenue service's approach to taxing unemployment benefits. If your state does tax these benefits, it may not have the wherewithal to withhold funds from your benefit checks. In other words, you may need to write a check to your state government after filing your state income taxes. If you know that your state doesn't withhold taxes on unemployment benefits, be sure to set aside a proportional amount of each benefit check to cover your expected tax bill.
To ensure that you receive a generous federal refund for your withheld benefits, claim the $2,400 deduction on line 3 of your Form-1040EZ. If you must file a Form-1940, you'll claim this deduction on line 19. In addition, be sure to claim any expenses related to your job search. These may include paper and utility costs as well as the cost of traveling to and from job interviews.