How Is UCE Income Treated for Taxes at the State and Federal Levels?

Understanding how UCE income is taxed now and whether any exclusions still apply can help avoid unexpected liabilities.

Taxpayers should be aware of how UCE affects both federal and state returns, as well as potential implications for adjusted gross income (AGI), reporting requirements, and penalties for misreporting.

Federal Return Inclusion

The Unemployment Compensation Exclusion (UCE) was a one-time provision under the American Rescue Plan Act (ARPA) for the 2020 tax year. It allowed eligible taxpayers to exclude up to $10,200 of unemployment benefits from federal taxable income if their modified adjusted gross income (MAGI) was below $150,000. This exclusion was not extended beyond 2020, so all unemployment benefits are now fully taxable at the federal level.

Unemployment compensation is considered ordinary income and must be reported on a federal tax return. Taxpayers who received unemployment benefits should have received Form 1099-G, which reports the total amount paid during the year. This amount is entered on Schedule 1 (Form 1040) and included in total income.

For those who did not have taxes withheld, there may be a balance due when filing. The IRS allows estimated payments throughout the year to avoid a large tax bill. Failure to do so could result in underpayment penalties, particularly for individuals with additional sources of income.

State-Specific Treatment

States tax unemployment benefits differently, and this variation became especially apparent when the federal UCE was introduced. Some states automatically conformed to federal tax changes, while others required legislative action. Several states never allowed the exclusion. This meant taxpayers who benefited from the federal exclusion in 2020 may have still owed state taxes on the full amount of their unemployment compensation, depending on where they lived.

Some states, including California, New Jersey, Pennsylvania, and Virginia, do not tax unemployment benefits, so the UCE had no impact on their state tax filings. Others, such as New York and Massachusetts, initially followed federal guidelines but later required taxpayers to add back the excluded amount to their state taxable income. This led to confusion for many filers, forcing some to amend their state filings or pay additional tax bills.

For states that do tax unemployment benefits, the method varies. Some use federal AGI as the starting point, meaning any federal exclusion would have automatically flowed through unless the state required an adjustment. Others, like Wisconsin and Mississippi, determine taxable income independently of federal AGI, leading to different treatment. Because state laws change frequently, taxpayers should review their state’s tax rules each year to ensure compliance.

Adjusted Gross Income Effects

Taxation of unemployment benefits directly affects AGI, which serves as the baseline for many tax calculations, deductions, and credits. Even a small increase in AGI can impact eligibility for tax benefits such as the Earned Income Tax Credit (EITC) and the Child Tax Credit (CTC), which phase out at higher income levels.

Medical expense deductions also depend on AGI, as only expenses exceeding 7.5% of AGI can be deducted. A higher AGI raises this threshold, reducing the amount of medical costs that can be claimed. Similarly, contributions to traditional IRAs may no longer be deductible if AGI surpasses certain limits, particularly for taxpayers with employer-sponsored retirement plans.

Beyond deductions and credits, AGI influences Medicare premiums under the Income-Related Monthly Adjustment Amount (IRMAA). Individuals with an AGI above specific thresholds pay higher Medicare Part B and Part D premiums. Additionally, student loan borrowers in income-driven repayment (IDR) plans may see their monthly payments increase, as these plans use AGI to determine payment amounts.

Reporting Documents

Accurate reporting of unemployment benefits is essential, given the varying state requirements and potential for discrepancies. The primary document for reporting unemployment compensation is Form 1099-G, issued by state unemployment agencies. This form details the total benefits received and any federal or state tax withholding. Taxpayers should verify that the information on Form 1099-G matches their records, as errors or fraudulent claims can lead to incorrect tax filings or IRS notices.

Taxpayers who had taxes withheld from their unemployment payments should confirm that these withholdings are correctly reported. The IRS allows voluntary withholding at a flat rate of 10% for federal taxes, but state withholding rules vary. Some states do not offer withholding on unemployment benefits, which can create an unexpected tax burden when filing. Reviewing pay stubs or online statements from the unemployment agency can help ensure that all withholdings were properly applied and reported.

High Income Threshold Issues

Taxpayers with higher earnings face additional complexities when it comes to unemployment benefits, particularly due to income-based phaseouts and tax bracket implications. Since unemployment compensation is treated as ordinary income, it can push individuals into a higher tax bracket, increasing their overall tax liability. This is especially relevant for those who had a mix of wages and unemployment benefits in the same year.

One issue arises with the Net Investment Income Tax (NIIT), which applies a 3.8% surtax on investment income for individuals with a MAGI exceeding $200,000 ($250,000 for married couples filing jointly). Since unemployment benefits contribute to MAGI, they can inadvertently trigger this additional tax for high earners with substantial investment income. Similarly, taxpayers subject to the Alternative Minimum Tax (AMT) may see an increased liability if their total income, including unemployment benefits, exceeds AMT exemption thresholds.

Potential Penalties for Noncompliance

Failing to report unemployment benefits properly can result in financial penalties and interest charges. Taxpayers who omit unemployment compensation from their returns may receive an IRS notice requesting additional taxes, along with interest accruing from the original due date. If the underreporting is significant, accuracy-related penalties of 20% of the underpaid amount may apply under Internal Revenue Code (IRC) Section 6662.

For more severe cases, where the IRS determines that income was intentionally omitted to evade taxes, civil fraud penalties of 75% of the underpayment may be assessed under IRC Section 6663. States also impose their own penalties for misreporting income, with some jurisdictions charging late payment penalties of up to 25% of the unpaid tax. Additionally, taxpayers who fail to pay estimated taxes on unemployment benefits may face underpayment penalties, particularly if their total tax liability exceeds $1,000 at year-end.