Order Code RS21356 Updated October 14, 2008 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 an income tax, UC benefits are taxed.3 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. CRS-2 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 Year 1998 1999 2000 2001 2002 2003 2004 2005 Number of Returns (millions) 7.1 6.8 6.5 8.8 10.3 10.1 9.1 7.9 Amount (millions of $) 16,777 17,649 16,982 26,891 43,130 44,008 32,740 27,857 Source: Table prepared by the Congressional Research Service (CRS) from data contained in the Internal Revenue Service, Statistics of Income Bulletins, various years. 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. CRS-3 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 Level of Individual or Couple Incomea Less than $10,000 $10,000 to $15,000 $15,000 to $20,000 $20,000 to $25,000 $25,000 to $30,000 $30,000 to $40,000 $40,000 to $50,000 $50,000 to $100,000 At least $100,000 All Unemployment Compensation Total Recipients of Benefits Affected Percent Total Taxes on Unemployment by Taxation of Affected Unemployment Benefits Compensation Benefits by Compensation (millions (thousands) (thousands of $) Taxation (millions of $) of $) 755 865 818 758 676 955 758 1,944 536 8,064 82 344 382 408 388 664 634 1,854 531 5,288 11 40 47 54 57 70 84 95 99 66 1,829 2,608 2,799 2,643 2,391 3,540 2,825 7,322 2,464 28,423 6 75 136 165 176 319 371 1,216 671 3,135 Taxes as a % of Total Benefits 0.3 2.9 4.9 6.3 7.4 9.0 13.1 16.6 27.2 11.0 Source: Congressional Budget Office (CBO). a. Income is defined as AGI plus statutory adjustments, tax-exempt interest, and nontaxable social security benefits. 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 exceeded $20,000 (single filers) or $25,000 (joint filers).7 Taxation was applied to the lesser of (1) UC benefits or (2) one-half of AGI (with UC benefits included) in excess of the abovementioned AGI thresholds.8 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...) CRS-4 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. 99514), 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 110th 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) 95th 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, 97th 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, 99th Congress; P.L. 99-514), JCS-10-87, May 4, 1987, pp. 29-30.