Reasons Why Unemployment Insurance Is Considered Taxable Income

It might seem that having to pay taxes on unemployment insurance benefits is adding insult to injury. The loss of your job is usually a financial setback. Receiving unemployment insurance benefits because you were laid off or for a reason that was not your fault can be a lifeline to pay your bills as you look for a new job. But it comes as a surprise to some people that unemployment benefits are considered taxable income by the federal government.

What is Income?

The Internal Revenue Service (IRS) uses a purposefully broad definition of income. Title 26 of the U.S. Tax Code defines income as "any gain in overall wealth over which you have complete control". Wages are a common type of income – wages are money you earned and which you have control over. Another form of income is debt forgiveness. Here, the money you no longer need to put toward the debt is considered a gain in wealth. With such a broad definition of income, it is not surprising that unemployment benefits are taxable.

Principle Behind Paying Benefits to Unemployed Workers

Unemployment insurance benefits arose from basic notions of fairness and public policy considerations. Congress and state legislatures prefer individuals to be gainfully employed; the ability to earn a living is a fundamental right. Individuals who lose their job through no fault of their own should not be punished for their change in circumstances; such individuals are generally entitled to collect unemployment insurance benefits. Unemployment benefits supplement an earner’s finances while that person seeks another job. The benefits are not an exact replacement for wages, but they are meant to help the worker get by.

How Unemployment Benefits are Calculated

Unemployment insurance benefits are essentially a form of supplemental income. The benefits are given to an earner based on various formulas (which vary by state), based on the amount of money the earner was making before she lost her job. The benefits meet the basic definition for income under the relevant Internal Revenue Code and so are taxable.

Income and Taxes if you have been Unemployed

Unemployment benefits are typically only subject to federal income taxation; not every state assesses a tax on unemployment benefits. While you need to check your state’s laws for specifics, it is more likely than not that you won’t be liable for taxes at the state level. Further, because unemployment benefits are only a portion of your original earnings, the tax assessed may not be as hefty as it would have been had you been working.

A tax preparation professional will be able to answer questions about your return when you have collected unemployment benefits during the year.