Texas Unemployment Benefits and Federal Tax: Withholding, 1099-G, and IRS Problems

When a Texan loses a job and files for benefits with the Texas Workforce Commission, money is tight and taxes are the last thing on anyone's mind. Texas has no state income tax, so many people assume the benefits are tax free. They are not. Federal law taxes unemployment compensation, and nobody withholds unless you ask.

The result is one of the most common IRS problems among working Texans: a balance due the year after a layoff, often when the household is still recovering.

Unemployment compensation is taxable: IRC 85

IRC 85 includes unemployment compensation in gross income. That covers state unemployment benefits paid by the TWC. There was a one-time partial exclusion for 2020 benefits, but it does not apply to other years.

Benefits are ordinary income, taxed at your regular rates. They are not subject to Social Security or Medicare tax, and they are not earned income for purposes of the earned income tax credit.

Form 1099-G

After the year ends, the TWC issues Form 1099-G showing total unemployment compensation paid and any federal income tax withheld. The IRS gets a copy. Report the amount on your return and claim any withholding.

If you do not report it, the IRS's matching program will notice. You will receive a proposed adjustment, typically a CP2000, adding the benefits and computing additional tax, interest, and possibly an accuracy-related penalty.

If the 1099-G is wrong, contact the TWC to correct it. Do not simply leave the income off your return. Report what you actually received and keep documents showing why the form is wrong.

Withholding: Form W-4V and the 10 percent option

You can ask to have federal income tax withheld from unemployment benefits. The IRS form is W-4V, Voluntary Withholding Request, and for unemployment compensation the withholding rate is 10 percent. The TWC generally lets you elect withholding when you apply or later through its systems.

Ten percent is a flat rate. If your other income for the year, such as wages before the layoff or a spouse's wages, puts you in a higher bracket, 10 percent may not be enough. If unemployment is your only income, it may be more than enough.

Estimated tax payments

If you did not elect withholding, consider quarterly estimated payments using Form 1040-ES or IRS Direct Pay. The underpayment penalty under IRC 6654 can apply when too little tax is paid during the year. The safe harbors generally require paying at least 90 percent of the current year's tax or 100 percent of last year's tax (110 percent if last year's adjusted gross income was over $150,000).

Many people who lose jobs mid-year had plenty withheld from their wages earlier in the year, which may cover the tax on the benefits. Run a projection before assuming you are short.

The rest of the layoff year: severance and retirement money

Unemployment benefits are rarely the only tax event in a layoff year. Severance pay is wages. It is subject to income tax withholding and Social Security and Medicare tax, and it is reported on your W-2. Employers often withhold on severance at a flat supplemental rate, which may or may not match your actual bracket.

Retirement withdrawals are the bigger trap. Cashing out a 401(k) to cover bills produces ordinary income, and if you are under 59 and a half, a 10 percent additional tax under IRC 72(t) generally applies unless an exception fits. One exception matters for laid-off workers: distributions from an employer plan after you separate from service in or after the year you turn 55. A direct payout from an employer plan also triggers mandatory 20 percent federal withholding under IRC 3405(c), which often falls short of the full tax plus the additional tax.

And job search costs are not deductible for employees under current law, because miscellaneous itemized deductions are suspended. Put all of this into one projection before April.

If you already owe

A balance due from unemployment benefits is usually modest, and the IRS has easy options for modest balances. A short-term payment plan or a streamlined installment agreement can often be set up online. If the balance is small enough to fall under IRC 6159(c), the statute requires the IRS to accept a payment plan that meets its conditions, including full payment within three years.

If you are still unemployed and cannot pay anything, ask about currently not collectible status. If penalties were charged, first-time abatement may remove the failure-to-pay penalty if you have a clean history. My penalty abatement guide explains how.

Can the IRS levy unemployment benefits?

IRC 6334(a)(4) generally exempts unemployment benefits from IRS levy. That is meaningful protection for someone already in trouble. There is a narrow exception: IRC 6331(h) allows the IRS, with approval, to make a continuous levy of up to 15 percent of certain specified payments, and the statute's list includes payments described in 6334(a)(4). In practice, the more immediate collection risks for a recently laid-off Texan are levies on bank accounts and on wages from a new job. My guides on bank levies and wage garnishment cover those.

If someone filed a fraudulent claim in your name

Unemployment identity theft became common in recent years. If you receive a 1099-G for benefits you never applied for or received, report the fraud to the TWC and ask for a corrected 1099-G showing zero. The IRS's guidance says you should not report the fraudulent benefits as income. Keep the TWC's confirmation in your records in case the IRS sends a matching notice.

If a corrected form does not arrive before your filing deadline, file accurately based on what you actually received and be ready to explain the difference.

Losing a job is hard. A federal tax bill a year later should not make it harder. Elect withholding if you can, report the 1099-G, and if you already owe, deal with it early while the options are easy. Let's talk: 813-229-7100. The firm's guide to what to do when you owe the IRS is a good starting point too.