This tax pitfall could affect millions due to Covid. Here's what you need to know

The 2020 tax season is officially underway, and the millions of Americans who collected unemployment benefits last year due to the coronavirus pandemic may be in for a surprise.

That unemployment income is taxable, and if you didn't have money set aside or withheld for those taxes, it could reduce your refund or even lead to a bill.

This might be particularly unexpected for independent contractors and self-employed people who normally aren't eligible for state benefits but may have received Pandemic Unemployment Assistance through the CARES Act.

"There are going to be a lot of people this year that have unemployment insurance and they do not normally receive unemployment insurance benefits," said Elaine Maag, a principal research associate at the Urban-Brookings Tax Policy Center. "So it will be something new that they have to pay attention to."

If you had any unemployment income last year, it is subject to taxes and needs to be reported on your 2020 income tax return. In January, those who had unemployment income should have received a Form 1099-G that spells out the amount of money paid out during the year.

Federal income taxes apply to these benefits — whether it's state unemployment insurance or the pandemic unemployment compensation disbursed under the CARES Act.

The catch is that withholding the appropriate amount of income tax is voluntary. You can opt to have a flat 10% of your benefits withheld to cover the tax liability.

In order to do this, you'd have to file Form W-V4 with the state agency administering your unemployment.

You can also choose to make quarterly estimated tax payments to the IRS.

Uncle Sam isn't the only entity seeking a slice of your unemployment income. Most states will tax these benefits, too.

A handful of states — Alabama, California, Montana, New Jersey, Pennsylvania and Virginia — don't tax these payments. Indiana and Wisconsin offer a partial exclusion of unemployment income, according to Andy Phillips, director at the Tax Institute at H&R Block.

"Some states have withholding, and others require it in order to alleviate surprises when tax time comes around," said Jared Walczak, vice president of state projects at the Tax Foundation.

Though it's too late to head off the taxes you might owe for 2020, individuals who wrap up their returns early can at least plan to pay the amount owed by April 15 — the due date for tax returns and liabilities owed.

"You don't have to make a payment until April 15, but it's better to know in late January or early February that you have to come up with the dollar amount by then," said Phillips at the Tax Institute at H&R Block.

Families who received unemployment income during 2020 should also be on the lookout for two key credits as they file their taxes: the earned income tax credit and the child tax credit.

Both credits add up to significant dollars — the earned income tax credit is worth up to $6,600 for a low-income household with three or more qualifying kids. And, the refundable portion of the child tax credit is worth up to $1,400 per qualifying child.

More from Smart Tax Planning:
Crypto falls in value. What it means for taxes
State tax departments set their sights on pro athletes
People fled from these high-tax states in 2020

The catch? While unemployment benefits are taxable, they aren't considered earned income.

Under normal circumstances, receiving unemployment would result in a reduction of both credits when you file your tax return.

Lawmakers fixed this problem in the year-end Covid relief act. This year, when you file your 2020 taxes, you'll have the option of using your 2019 income to calculate eligibility for the credit.

"If you went from being a wage earner to applying for unemployment, you can be affected," said Phillips. "Using your 2019 earned income just for figuring the amount of credits can be a huge benefit for taxpayers."