The Bad News
Yes, unemployment benefits are considered to be income and are subject to federal tax. I know it seems like the government is giving with one hand and taking back with the other, but that's how they roll. The Good News
Fortunately, the American Recovery and Reinvestment Act (aka "the stimulus package") does provide some tax relief to unemployment benefit recipients. For the 2009 tax year the first $2,400 of benefits will not be taxed by the IRS. See following article on the IRS website for further details:
Advice
Elect to have federal taxes automatically withheld from your weekly unemployment payments in order to avoid a big tax bill when you do your taxes. The 10% withholding can be setup when you apply for unemployment benefits or at any time while receiving those benefits. Alternatively, you could elect to make quarterly estimated tax payments, however, this is more time consuming than the withholding option.
The state will provide you with Form 1099-G which shows your taxable benefits and amount of withholding for the year. You will then use these figures when preparing your tax return to the IRS. You should receive Form 1099-G by January 31, 2010.
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