A more detailed explanation of the $10,200 unemployment exclusion

by LiteBulb88

There have been a lot of requests asking for an ELI5 version of the $10,200 unemployment compensation exclusion post. So this is my attempt at that; in particular, I want to talk about the concept of withholding taxes and what it means and doesn’t mean toward the UCE.

I’ll start with the general concept of withholding. Simply put, tax withholding (in any context) is a GUESS. It is almost never exactly correct. Whoever is withholding your money is guessing how much tax you’ll have to pay on the money they’re giving you. And a guess is the best they can do–no one can know exactly how much tax you need to pay until the end of the year, but the IRS wants the money during the year, not at the end of the year. That’s why you file your taxes at the beginning of the next year–to reconcile the withholding (guesses) from the previous year to what you actually should have paid. For example, if your job guessed that you should have paid $1,500 in tax but you really should have paid $1,000 in tax, then your job paid $500 too much to the IRS on your behalf and you get that back when you file.

How does this apply to unemployment? If you had money withheld from your unemployment, like all withholding, it was a guess. It wasn’t even a very educated guess–just a flat 10% no matter what other income you had or didn’t have. (And some states screwed that up and didn’t tax 10% of all unemployment income.) So even if the UCE didn’t exist, you would still need to file your taxes this year to reconcile that guess with the amount you really should have paid.

All that said, the UCE does NOT subtract from your withholding. It subtracts from how much unemployment you received, not how much tax was withheld. Your withholding or lack thereof actually makes no difference in how the UCE works. Withholding will change how much you owe or get refunded, but it doesn’t change how much you *should* have paid to the IRS during the year.

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Let me illustrate with a simple example. Let’s say you’re single, you got $25,000 in unemployment in 2020 and had no other income. If you withheld and lived in a state that got it right, 10% of that was taken out, or $2,500. That’s the guess that was made. Now let’s look at how much tax you actually owe. Before I run the numbers, let me explain that in 2020, everybody got to deduct $12,400 from their income before they pay a cent of tax. That’s called the standard deduction. (It is possible to increase that in some cases by itemizing, but that’s beyond the scope of this post.) So now for the numbers:

Income: $25,000

Deduction: $12,400

Taxable income: $25,000-$12,400 = $12,600.

Actual tax owed: $1,318.

How did I get that last figure? By looking it up in the IRS tax table. Don’t worry if that table looks intimidating–any decent tax software has that table programmed in.

Now we need to reconcile. During 2020, you paid $2,500 in taxes to the government–that was the (very naïve) guess that was made as to how much tax you owed. But you only really owed $1,318. So you get the difference back. $2,500-$1,318 = $1,182 goes back to your pocket after you file. Of course, it’s money you already paid, so in reality you gave the government an interest free loan. But I digress.

Now let’s apply the Unemployment Compensation Exclusion (UCE). The UCE states that, under most circumstances, the first $10,200 of your unemployment income isn’t taxable. (Of course, the UCE can’t be more than the actual amount of unemployment you received during the year, so if you received $7,500 in unemployment, then your UCE is $7,500, not $10,200.) To apply this to the example above:

Income: $25,000

UCE: -$10,200

Taxable income before deduction: $25,000 – $10,200 = $14,800

Deduction: $12,400

Taxable income: $14,800-$12,400 = $2,400

Actual tax owed: $241 (again, from the IRS tax table)

Tax you’ll get back: $2,500 (this was the guess made during the year) – $241 (actual tax owed) = $2,049

So in this example, the UCE netted you an extra $867 ($2,049-$1,182).

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Some key points:

  • No matter what, if you got unemployment benefits in 2020 and had tax withheld, you must file taxes. This would be true even if the $10,200 UCE didn’t exist. This is how you reconcile the withholding (the guesses) made during the year with how much you truly should have paid.
  • It’s impossible to say exactly how much money you’ll get back from the UCE without actually calculating the exact tax based on all of your numbers–we can make educated guesses, but there’s no shortcut to get the exact amount, and our guess could be way off. So if you really want to know, you should run your taxes twice in your favorite tax software: once without the UCE and once with the UCE. Then compare the results. And of course, make sure you run *all* your numbers for both scenarios–include any other income you got (jobs, bank interest, etc.) and any withholding that was taken out as well.
  • If you’ve already filed, had any unemployment income, and are eligible for the UCE, then your tax burden will almost certainly be reduced, and you almost certainly will get money back. The IRS is still working out how they’ll handle this situation, so sit tight and bookmark www.irs.gov/newsroom/irs-statement-american-rescue-plan-act-of-2021 .
  • I haven’t talked about how the UCE can make you eligible for various tax credits or increase the size of those credits if you were eligible for them in the first place. That’s beyond the scope of this post, but just know if your income was low, you might get a small or even large extra boost from those credits. Any decent tax software will calculate which credits you’re eligible for.
  • I focused on federal taxes in this post, but the same concepts will apply for state taxes if you had those withheld.

Hope this helps.

 

Disclaimer: This is a guest post and it doesn’t necessarily represent the views of IWB.

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