How is unemployment insurance funded and taxed?

Funding for Unemployment Insurance comes from a small payroll tax that employers pay for 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.

People who receive unemployment benefits also pay taxes on them. The benefits 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, those taxes aren’t automatically withheld. Recipients have to opt in to withholding income taxes from their benefits by filling out a W-4V form or send quarterly estimated payments to the IRS. If they don’t, people who receive unemployment benefits face a large tax bill, and possibly even a financial penalty, when they file their annual taxes.

During the pandemic, some states, like California, never offered the option to withhold 10 percent for taxes, and less than 40 percent of all UI payments in the country in 2020 appear to have had taxes withheld, meaning 60 percent of UI recipients in 2020 could be hit with a surprise tax bill. Several, but not all, states either do not have an income tax, already did not tax UI benefits, or have exempted UI benefits from 2020 from their state income tax. Under the American Rescue Plan, the first $10,200 of UI benefits from 2020 are exempted from the federal income tax.