Taxation of Unemployment Benefits

Taxation of Unemployment Benefits
Julie M. Whittaker
Specialist in Income Security
Domestic Social Policy Division
Summary
Unemployment compensation (UC) benefits have been fully subject to the federal
income tax since the passage of the Tax Reform Act of 1986 (P.L. 99-514). Individuals
who receive UC benefits during a year may elect to have the federal (and in some cases
state) income tax withheld from their benefits. H.R. 6844 would provide a two-year
suspension of the taxation of UC benefits.
This report¹ provides an overview of the taxation of UC benefits and legislation
related to taxing UC benefits. This report will be updated as legislative activity warrants.
Overview
Unemployment compensation (UC)² benefits are fully subject to the federal income
tax. This tax treatment, which has been in place since 1987, puts UC benefits on a par
with wages and other ordinary income with regard to income taxation.
In addition to being subject to federal income taxes, in most states that have an³
income tax, UC benefits are taxed. Most other industrial nations also tax unemployment
benefits.

¹ This report was originally written by Christine M. Scott. All inquiries should be directed to the
current author listed.
² In law, this program is called the UC program. However, it is commonly referred to as the UI
program, reflecting the social insurance design. For more information regarding the UC program,
see CRS Report RL33362, Unemployment Insurance: Available Unemployment Benefits and
Legislative Activity, by Julie M. Whittaker.
³ Although most states tax UC benefits, some states exempt the benefits from state income taxes.
A few states impose a lowered tax rate on unemployment benefits. Information on a particular
state tax treatment of unemployment benefits should be available at the appropriate state tax
authority.

State UC agencies must give UC beneficiaries the opportunity to elect federal
income tax withholding at the time the claimant first files for UC benefits. Benefits
claimants wishing to have federal income tax withheld from their UC benefits must file
form W-4V, Voluntary Withholding Request. The current withholding rate for federal
income tax is 10% of the gross UC benefits payment. Federal law does not require that
states offer state income tax withholding to UC beneficiaries.
Impact of Taxing UC Benefits
Table 1 shows the number of federal income tax returns that reported unemployment
benefits and the amount of unemployment benefits for tax years 1998-2005.⁴ The
increases in tax returns filed in 2001 through 2003 are attributable to the 2001 economic
recession and the policy responses including the extension of UC benefits and providing
additional benefits for individuals impacted by the 2001 terrorist attack.
Table 1. Returns With Unemployment Benefits and Amount of
UC Benefits, Tax Years 1998-2005
YearNumber of Returns(millions)Amount(millions of $)
19987.116,777
19996.817,649
20006.516,982
20018.826,891
200210.343,130
200310.144,008
20049.132,740
20057.927,857
^Source:^T^a^{ble pr}^e^p^{ared by}^th^{e C}^oⁿ^g^r^es^sⁱ^on^{al R}^e^s^earch^Serv^{ice (C}^R^S^{) f}^r^om^data
^c^o^nt^aⁱ^ne^dⁱⁿ^t^h^e^Iⁿ^t^e^rⁿ^a^l^Re^ve^nue^Se^r^vⁱ^c^e^,^S^t^a^{tistics o}^f^Iⁿ^co^{me Bu}^lletin^s^{, v}^a^riou^s
^y^ears^.
Typically, the loss of a job, even with unemployment benefits, results in a decline
in earned income and often in total income. Unemployment benefits are not considered
earned income for purposes of computing the earned income tax credit, and the earned
income tax credit is not available if adjusted gross income⁵ (AGI) exceeds a certain level,

⁴ Unemployment benefits include regular and extended UC benefits, trade adjustment assistance
benefits, disaster unemployment assistance, and railroad unemployment benefits.
⁵ The IRS defines AGI as taxable income from all sources including wages, salaries, tips, taxable
interest, ordinary dividends, taxable refunds, credits, or offsets of state and local income taxes,
alimony received, business income or loss, capital gains or losses, other gains or losses, taxable
IRA distributions, taxable pensions and annuities, rental real estate, royalties, farm income or
losses, unemployment compensation, taxable social security benefits, and other income minus
specific deductions including educator expenses, the IRA deduction, student loan interest
deduction, tuition and fees deduction, Archer MSA deduction, moving expenses, one-half of
self-employment tax, self-employed health insurance deduction, self-employed SEP, SIMPLE,
and qualified plans, penalty on early withdrawal of savings, and alimony paid by the tax payer.

or if investment income (interest, dividends, and capital gains distributions) exceeds a
certain level.⁶
Table 2 shows Congressional Budget Office (CBO) estimates of the effect of taxing
unemployment compensation at various income levels. Families that reported an income
of less than $10,000 in 2005 received an estimated $1.8 billion in UC benefits but only
paid $6 million in taxes on those benefits. In comparison, families reporting an income
between $50,000 and $100,000 received an estimated $7.3 billion in unemployment
benefits and paid $1.2 billion in taxes on those benefits.
Table 2. Estimated Effect of Taxing Unemployment Compensation,
by Income Class, 2005
^Uⁿ^e^m^pl^oy^m^e^nt
^Com^p^en^sation^To^ta^l
^Reci^pⁱ^en^{ts of}^B^eⁿ^e^{fits Affected}^P^ercen^t^To^ta^l^Ta^x^e^{s o}ⁿ^Ta^x^e^s
^Uⁿ^e^m^pl^oy^m^e^nt^by^T^a^x^a^tⁱ^{on of}^Affected^Uⁿ^e^m^pl^oy^m^e^nt^B^eⁿ^e^fits^{as a %}
^L^e^vel^of^Indi^vi^dual^a^Com^p^en^sation^B^eⁿ^e^fits^by^Com^p^en^sation^(m^illions^of^T^o^t^a^l
^{or Cou}^p^l^{e In}^com^e⁽^t^hous^a^nds⁾⁽^t^hous^a^nds^of^$)^Ta^x^a^tioⁿ^(m^{illions of}^$)^of^$)^B^eⁿ^e^fits
^L^e^s^s^t^h^an^$10,000⁷⁵⁵⁸²¹¹^1,829⁶⁰^.3
^{$10,000 t}^o^$15,000⁸⁶⁵³⁴⁴⁴⁰^2,608⁷⁵^2.9
^{$15,000 t}^o^$20,000⁸¹⁸³⁸²⁴⁷^2,799¹³⁶^4.9
^{$20,000 t}^o^$25,000⁷⁵⁸⁴⁰⁸⁵⁴^2,643¹⁶⁵^6.3
^{$25,000 t}^o^$30,000⁶⁷⁶³⁸⁸⁵⁷^2,391¹⁷⁶^7.4
^{$30,000 t}^o^$40,000⁹⁵⁵⁶⁶⁴⁷⁰^3,540³¹⁹^9.0
^{$40,000 t}^o^$50,000⁷⁵⁸⁶³⁴⁸⁴^2,825³⁷¹^13.1
^{$50,000 t}^o^$100,000^1,944^1,854⁹⁵^7,322^1,216^16.6
^A^t^l^eas^t^$100,000⁵³⁶⁵³¹⁹⁹^2,464⁶⁷¹^27.2
^A^l^l⁸^,064^5,288⁶⁶^28,423^3,135^11.0
^Source:^C^oⁿ^g^r^es^sⁱ^on^{al B}^u^dg^{et Of}^fⁱ^{ce (C}^B^O^).
^{a. In}^com^e^is^defⁱⁿ^e^d^as^A^G^I^plu^s^s^t^atu^t^ory^adj^u^s^t^m^eⁿ^t^s^,^tax^-^ex^em^{pt in}^teres^t^{, an}^{d n}^oⁿ^t^ax^{able s}^o^{cial s}^ecu^rity
^b^eⁿ^e^f^its.
Legislative History
Before 1979, UC benefits were not subject to the federal income tax. In the Revenue
Act of 1978 (P.L. 95-600), UC benefits were made partially taxable for benefits received
after December 31, 1978. Benefits were taxable only for tax filers whose AGI exceeded⁷
$20,000 (single filers) or $25,000 (joint filers). Taxation was applied to the lesser of (1)
UC benefits or (2) one-half of AGI (with UC benefits included) in excess of the above-⁸

mentioned AGI thresholds.
⁶ For example, for tax year 2005, an adjusted gross income of more than $11,750 would
disqualify a single taxpayer with no children, an adjusted gross income of more than $37,263
would disqualify a married couple with two children. Investment income of more than $2,700
would disqualify any taxpayer.
⁷ If the thresholds were adjusted for inflation, the comparable 2007 values would be $57,120 and
$71,400.
⁸ Joint Committee on Taxation, General Explanation of the Revenue Act of 1978 (H.R. 13511,
(continued...)

During the 1970s, some policy studies had shown that the proportion of wages
replaced by UC benefits on an after-tax basis was large enough to erode a claimant’s work
incentive.⁹ Taxation of UC benefits served to reduce the degree of after-tax wage
replacement and reduce the work disincentive effect. However, UC benefits of lower
income claimants remained untaxed because their total income was under the tax
threshold (i.e., their standard deduction and personal exemptions offset their income).
In 1982, Congress lowered the AGI thresholds for taxation of UC benefits. The Tax
Equity and Fiscal Responsibility Act of 1982 (P.L. 97-248) reduced those thresholds to
$12,000 for single filers, and $18,000 for joint filers.¹⁰ A primary motivation of this
legislation was to raise revenue, but it left in place a policy of protecting lower income
claimants from taxation of UC benefits.¹¹
Congress made UC benefits fully taxable in the Tax Reform Act of 1986 (P.L. 99-
514), effective for benefits received after December 31, 1986. Although this action
reversed the original policy of taxing UC benefits only above an AGI threshold, it
occurred in the context of a law that removed many low-income filers from the tax rolls,
lowered the marginal tax rates for the majority of taxpayers, and expanded eligibility for
the earned income credit. The rationale for full taxation of UC benefits was to treat UC
benefits the same as wages and to eliminate the work disincentive caused by favorable tax
treatment for UC benefits relative to wages.¹²
Concern about claimants’ cash flow problems caused by the lack of tax withholding
from UC benefits arose during the 1990-1991 recession. P.L. 102-318 required states to
inform all new claimants of their responsibility to pay income tax on UC benefits and to
provide them with information on how to file estimated quarterly tax payments. In 1994,
P.L. 103-465 required states to withhold federal income tax from UC benefits if a
claimant requested withholding, and permitted states to withhold state and local income
taxes. P.L. 103-465 set the federal withholding rate at 15% of the gross benefit payment
amount. The federal withholding rate was changed to 10% by the Economic Growth and
Tax Relief Reconciliation Act of 2001 (EGTRRA, P.L. 107-16) effective August 7, 2001.
Legislation in the 110^th Congress
On September 9, 2008, the Suspension of Federal Income Tax on Unemployment
Benefits Act of 2008 (H.R. 6844, McHugh), was introduced. This bill would temporarily
suspend the inclusion of UC benefits for federal tax purposes for 2008 and 2009.

⁸ (...continued)

95^th Congress, P.L. 95-600), March 12, 1979, p. 23.

⁹ For example, see Martin Feldstein, “Unemployment Compensation: Adverse Incentives and
Distributional Anomalies,” National Tax Journal, June 1974.
¹⁰ If the thresholds were adjusted for inflation, the comparable 2007 values would be $25,780
and $38,680.
¹¹ Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Tax
Equity and Fiscal Responsibility Act of 1982 (H.R. 4961, 97^th Congress; P.L. 97-248), December

31, 1982, pp. 28-29.

¹² Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986 (H.R. 3838,

99^th Congress; P.L. 99-514), JCS-10-87, May 4, 1987, pp. 29-30.