Income

• There is really only one reason why unemployment insurance benefits are considered taxable income, and that is because it is income. This money is designed to replace what would otherwise be taxable income from your employer, so the benefit itself is taxable as well. If you had a tax incentive to receive unemployment benefits, you may not be as inclined to find gainful employment as quickly. Additionally, tax revenue would decrease dramatically at both the federal and state level, and government services would suffer.
  
  

Reduced Pay

• The taxation issue is logical when you consider unemployment benefits as a replacement to taxable income. Still, because the benefit is already reduced from the level of income you enjoyed while working, you may have trouble feeling good about the dollar amount declining even further because of taxes. However, one of the reasons the benefits are smaller than your prior income is to provide an incentive to go back to work, rather than enjoying a government-sponsored vacation at the same rate of pay.
  
  

Withholdings

• Unless you request otherwise, unemployment benefits do not usually have federal or state income taxes withheld, but this does not exempt the money from taxation. If you do not plan for tax time and instead spend all the money as if it belongs to you, you may face an unpleasant tax surprise the following year. However, you may need all the unemployment money simply to pay bills in the meantime. DebtHelp.com recommends, if possible, using all the unemployment money while you are between jobs and requesting additional withholdings from your paycheck to compensate when you go back to work.
  
  

Some Exemptions

• Though not common, there are some types of unemployment compensation that are exempt from income taxes. Some people contribute to private or public unemployment funds separate from the state unemployment fund your employer pays into on your behalf. If you draw benefits from one of these funds, you do not owe any taxes until you receive a benefit greater than your contribution. For example, if you pay $1,800 into the fund, the first $1,800 of compensation is tax-exempt.