$10,200 in unemployment benefits won’t be taxed thanks to American Rescue Plan

The $1.9 trillion American Rescue Plan signed into law this week includes a welcome tax break for unemployed workers. The law waives federal income taxes on up to $10,200 in unemployment insurance benefits for people who earn under $150,000 a year, potentially saving workers thousands of dollars. States that currently tax unemployment benefits have yet to decide whether they will allow those state taxes to be waived as well.

The change is good news for many taxpayers, who could save as much as $25 billion, according to the Wall Street Journal. But it also affects an already complex tax season for a tax collection agency that is already behind thanks to understaffing and pandemic-fueled disruptions.

Wait, unemployment is taxable?

In most years, yes. The federal government considers unemployment benefits to be taxable income, although taxes are not automatically withheld from benefits payments, the way an employer might take taxes out of your paycheck. Instead, unemployment recipients must request that taxes be withheld from their benefits form, and the withholding is limited to 10%.

This led to confusion and angst for the unprecedented number of workers who received jobless benefits for part of 2020 and filed their taxes for the year only to find their typical refund reduced — or in some cases to be told they owe money. 

Michigan resident Bridget Harwood was furloughed from her medical assistant job for three months last year when many businesses in her city closed. The unemployment benefits she received during that time  also resulted in a smaller tax refund this year.  Instead of the roughly $1,500 refund she typically receives, she got just $72 back.

“It was definitely a shock,” Harwood said. 

It was even worse for Harwood’s eldest daughter, who worked at a fast-food restaurant before the pandemic pushed her into unemployment. Harwood filled out her daughter’s tax return and found that she owed $1,000 in federal and state taxes. When Harwood explained the situation to her daughter — who had been expecting a refund to put toward a new car — she “started to cry,” Harwood said.

A “monkey wrench” in 2020 taxes

Under the changes in the new law, a person who was unemployed for some or all of 2020 could potentially save thousands in taxes. Someone who received $10,200 or more in unemployment benefits, and is in the 10% tax bracket, could save $1,200 on federal income taxes, assuming their adjusted gross income for the year was less than $150,000. (Taxpayers in higher tax brackets would save more.)

However, the fact that the tax law was changed a month after the IRS started accepting taxes promises to further complicate an already challenging filing season.

The IRS has not yet issued guidance on how taxpayers who may have been told they owe money under the old tax law can reclaim any money they may have overpaid under the new law. CBS MoneyWatch has reached out for clarification on what those taxpayers should do.

Tax pros say it’s likely those people will need to file an amended return. But they — as well as people who haven’t filed yet — advise individuals to wait to give the IRS time to issue guidance, and for the tax software to catch up with the new law.

The law “is going to put a monkey wrench in the 2020 filings,” said Jonathan Medows, a CPA based in Manhattan. “It’s a cascade – the IRS is backed up, software companies are backed up, practitioners are backed up.”

What to do if you haven’t filed your taxes: Wait

Taxpayers who received Paycheck Protection Program loans or unemployment benefits last year are best off waiting to file for two reasons, tax experets say. First, it will take at least a few days, if not longer, for tax software to reflect recent changes in the law. 

“I have two stacks of returns that I can’t file right now,” said Rob Seltzer, a CPA based in Los Angeles. “I have one client that got $15,000 in unemployment. If I filed her return, it wouldn’t work,” he said.

Second, some states may change their tax law to follow the federal guidance. States including Alabama, California, Montana, New Jersey, Pennsylvania and Virginia already exempt unemployment benefits from taxation. Other states that tax unemployment may decide not to do so this year.

Many taxpayers have held off on filing their taxes so far. About 12 million fewer tax returns were filed in early March this year than in 2020, according to IRS figures.

If you already filed, you may need to amend

Taxpayers who already filed their taxes will likely need to file an amended return. However, many advocates have called for the IRS to take action and issue refunds to taxpayers who overpaid.

One such advocate is Nina Olson, the former National Taxpayer Advocate, who has called for the IRS to amend taxpayers’ returns, telling Politico that it was within the tax agency’s purview to automatically correct already-filed returns. The alternative — digging through a mountain of amended returns—”really does create more processing burden for the IRS,” which started this season with a backlog from last year, Olson said.

More time to file?

All these changes are spurring calls for the IRS to extend its 2020 tax filing deadline this year. The National Conference of CPA Practitioners has called for the agency to delay the deadline and hold off on collecting penalties until it works through its pileup. Democrats in Congress, including House Ways and Means Chairman Richard Neal and Oversight Subcommittee Chairman Bill Pascrell, have also called for a tax filing deadline extension.

The IRS has so far stuck to the April 15 filing deadline for most Americans, although roughly 10% of taxpayers who live in Texas have already received a two-month extension.

As for Bridget Harwood, she’s holding off on filing her children’s tax returns until the IRS issues clearer guidance, but has already sent hers in. “If I have to amend it, then I can go back and amend it,” she said.