How is unemployment insurance funded and taxed?

Employers are charged a small payroll tax on each employee’s first several thousand dollars of earnings. Alaska, New Jersey, and Pennsylvania levy a tax on employees as well.

Employers pay different amounts depending on how many of their past workers have filed for Unemployment Insurance in the past three years. Employers who have laid off more workers have to contribute more, because they cost the system more.

Unemployment benefits are taxable income. They are not subject to Medicare or Social Security taxes, but recipients do have to pay federal, and oftentimes state, income taxes on their unemployment checks. Of the 43 states with an income tax, just six — California, Montana, New Jersey, Oregon, Pennsylvania, and Virginia — currently exempt unemployment benefits from state income taxes.

However, unlike standard paychecks, recipients have to opt in to withholding income taxes from their benefits by filling out a W-4V form to withhold a flat 10 percent from each check. If they don’t, they will likely have to send quarterly estimated payments to the IRS, or else face a large tax bill, and possibly even a financial penalty, the following spring.