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Money you earn from working is earned income. The IRS considers all other income, including unemployment benefits, as unearned income. You must pay federal income tax on unemployment compensation, and most states require you to pay state taxes on your unemployment benefits also. One hundred percent of unemployment benefits are subject to tax, provided you earn enough income to require you to pay taxes.
When you file for unemployment, you have the option of requesting your state's unemployment office withhold taxes from each benefit check. This reduces the amount of your check but avoids the problem of having to coming up with a large sum of money to pay the taxes you owe at tax time. Your unemployment office can tell you how much your check will be after they deduct taxes.
If you choose not to have taxes withheld, you could be required to make quarterly tax payments to the IRS while you receive unemployment. The IRS requires you to make quarterly estimated tax payments if you expect to owe $1,000 or more in taxes at the end of the year. Complete Form 1040-ES -- Estimated Tax for Individuals -- to compute how much tax you'll need to remit each quarter. If you fail to pay your quarterly taxes, you could be charged a penalty.
Your unemployment office will provide you with a Form 1099-G, which shows how much you received in unemployment compensation, and how much taxes, if any, were withheld from this amount. You report this income on your form 1040, in the space for unemployment compensation. This is added to your other earnings to compute your gross income.
Other Types of Benefits
If you receive unemployment payments from a fund set up by your company, instead of or in addition to state or federal unemployment benefits, the IRS considers these benefits as wages. You'll owe income tax and Social Security and Medicare tax on these wages. Worker's compensation benefits are not considered unemployment benefits or unearned income and are not subject to income tax.