Taxation of Unemployment Benefits Julie M. Whittaker Specialist in Income Security January 17, 2012 Congressional Research Service 7-5700 www.crs.gov RS21356 CRS Report for Congress Prepared for Members and Committees of Congress Taxation of Unemployment Benefits 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. The American Recovery and Reinvestment Act of 2009 (P.L. 111-5 §1007) included a temporary exclusion on the first $2,400 of UC benefits for the purposes of the federal income tax. This exclusion existed only in 2009. The Joint Committee on Taxation estimated this would reduce federal receipts by approximately $4.7 billion. There is no federal income tax exclusion for unemployment benefits for tax years 2010 or 2011. The Workforce Fairness and Tax Relief Act of 2011 (H.R. 2806) would repeal the taxation of unemployment benefits and any trade adjustment assistance payments. This report 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. Congressional Research Service Taxation of Unemployment Benefits Contents Overview.......................................................................................................................................... 1 Impact of Taxing UC Benefits ......................................................................................................... 1 Legislative History........................................................................................................................... 3 Legislation in the 112th Congress..................................................................................................... 4 Legislation in the 111th Congress..................................................................................................... 4 Tables Table 1. Returns With Unemployment Benefits and Amount of UC Benefits, Tax Years 1998-2009..................................................................................................................................... 2 Table 2. Estimated Effect of Taxing Unemployment Compensation, by Income Class, 2005 .............................................................................................................................................. 3 Contacts Author Contact Information............................................................................................................. 5 Acknowledgments ........................................................................................................................... 5 Congressional Research Service Taxation of Unemployment Benefits Overview Unemployment benefits are subject to the federal income tax. This tax treatment, which has been in place since 1987, puts unemployment benefits on an equal basis with wages and other ordinary income with regard to income taxation. Unemployment benefits are not subject to employment taxes, including Social Security and Medicare taxes, because the benefits are not considered to be wages.1 For tax year 2009 only, the first $2,400 of unemployment compensation (UC) benefits was excluded from the federal income tax. For tax years 2010 and 2011 no UC benefits are excluded. In addition to being subject to federal income taxes, in most states that have an income tax, UC benefits are taxed.2 Most other industrial nations also tax unemployment benefits. 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, although many do offer such services. Beneficiaries may opt to pay quarterly estimated taxes if a state does not offer state income tax withholding. 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 through 2009.3 The increases in the number of tax returns claiming unemployment benefits as income 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 affected by the 2001 terrorist attack. The most recent recession that began in December 2007 is reflected in the sharp increases in 2008 and 2009 tax returns with an estimated additional 3.7 million tax returns claiming unemployment benefits as income in 2009 as compared with tax filings for 2007. 1 The federal and state unemployment taxes (FUTA and SUTA) on employers also do not apply to these benefits. 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. 3 Unemployment benefits include regular and extended UC benefits, trade adjustment assistance benefits, disaster unemployment assistance, and railroad unemployment benefits. 2 Congressional Research Service 1 Taxation of Unemployment Benefits Table 1. Returns With Unemployment Benefits and Amount of UC Benefits, Tax Years 1998-2009 Year Number of Returns (millions) Amount (millions of $) 1998 7.1 16,777 1999 6.8 17,649 2000 6.5 16,982 2001 8.8 26,891 2002 10.3 43,130 2003 10.1 44,008 2004 9.1 32,740 2005 7.9 27,857 2006 7.4 26,524 2007 7.6 29,415 2008 9.5 43,675 2009 11.3 83,538 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 income4 (AGI) exceeds a certain level or if investment income (interest, dividends, and capital gains distributions) exceeds a certain level.5 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. 4 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. 5 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. Congressional Research Service 2 Taxation of Unemployment Benefits Table 2. Estimated Effect of Taxing Unemployment Compensation, by Income Class, 2005 Recipients of UC (thousands) UC Benefits Affected by Taxation of Benefits (thousands of $) Percentage Affected by Taxation Less than $10,000 755 82 $10,000 to $15,000 865 $15,000 to $20,000 Total UC (millions of $) Total Taxes on Benefits (millions of $) Taxes as a % of Total Benefits 11 1,829 6 0.3 344 40 2,608 75 2.9 818 382 47 2,799 136 4.9 $20,000 to $25,000 758 408 54 2,643 165 6.3 $25,000 to $30,000 676 388 57 2,391 176 7.4 $30,000 to $40,000 955 664 70 3,540 319 9.0 $40,000 to $50,000 758 634 84 2,825 371 13.1 $50,000 to $100,000 1,944 1,854 95 7,322 1,216 16.6 536 531 99 2,464 671 27.2 8,064 5,288 66 28,423 3,135 11.0 Level of Individual or Couple Incomea At least $100,000 All 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).6 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-mentioned AGI thresholds.7 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.8 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). 6 If the thresholds were adjusted for inflation, the comparable 2007 values would be $57,120 and $71,400. Joint Committee on Taxation, General Explanation of the Revenue Act of 1978 (H.R. 13511, 95th Congress, P.L. 95600), March 12, 1979, p. 23. 8 For example, see Martin Feldstein, “Unemployment Compensation: Adverse Incentives and Distributional Anomalies,” National Tax Journal, June 1974. 7 Congressional Research Service 3 Taxation of Unemployment Benefits 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.9 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.10 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.11 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. 10716) effective August 7, 2001. Legislation in the 112th Congress On August 5, 2011, Representative Michaud introduced the Workforce Fairness and Tax Relief Act of 2011, (H.R. 2806). The bill would repeal the taxation of unemployment benefits and any trade adjustment assistance payments. It would also eliminate the penalty for distributions from a qualified retirement plan to an individual after separation from employment if the individual had received at least 24 weeks of UC. The bill would apply to benefits received after December 31, 2010. Legislation in the 111th Congress The American Recovery and Reinvestment Act of 2009 (P.L. 111-5 §1007) included a temporary exclusion on the first $2,400 of UC benefits for the purposes of the federal income tax. This exclusion applied only for the 2009 tax year. The Joint Committee on Taxation estimated that this exclusion would reduce federal receipts by approximately $4.7 billion. 9 If the thresholds were adjusted for inflation using the All Items Consumer Price Index for All Urban Consumers (CPIU), the comparable 2011 values would be $28,132 and $42,198. 10 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. 11 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. Congressional Research Service 4 Taxation of Unemployment Benefits Among many provisions, S. 2831 would have suspended the federal taxation of the first $2,400 of unemployment benefits through 2010. H.R. 4718 would have suspended the federal taxation of all unemployment benefits through 2012. Author Contact Information Julie M. Whittaker Specialist in Income Security jwhittaker@crs.loc.gov, 7-2587 Acknowledgments This report was originally written by Christine M. Scott. All inquiries should be directed to the current author listed. Congressional Research Service 5