How Unemployment Insurance Works

A Cushion to Catch Laid off Workers During Hard Economic Times

Mar 3, 2009

Unemployment benefits provide much-needed income for those who have been caught up in layoffs. Here's how it works.

In the midst of staggering unemployment and poverty during the United States’ Great Depression arose a New Deal and new legislation aimed at bolstering a battered and torn economy. The Social Security Act of 1935 created a safety net for Americans who needed financial assistance for unemployment, disability, retirement, and other life situations where they may find themselves without an income through no fault of their own.

In 1939, the Federal Unemployment Tax Act (FUTA) set the unemployment compensation-related provisions of the Social Security Act into motion, creating a joint state-federal program of unemployment insurance. According to the U.S. Department of Labor, FUTA authorizes the Internal Revenue Service (IRS) to collect a federal employer tax in order to fund state workforce agencies. Today, unemployment insurance remains an important cushion for laid-off workers and helps to stimulate the economy during recessionary periods.

How Unemployment Insurance is Funded

Contrary to popular belief, unemployment insurance is not funded by individual taxpayer dollars. Rather it is funded by the employer who, pursuant to FUTA, is mandated by the IRS to pay a certain percentage of taxable wages in state and federal unemployment taxes.

In turn, the unemployment taxes collected by the IRS go toward funding state unemployment insurance and workforce programs. Ultimately, the unemployment insurance program accomplishes its goal when laid-off workers are able to file for and receive unemployment benefits from their state of residence.

Is Unemployment Taxes an Undue Burden on Employers and Small Businesses?

Companies universally agree that hiring and keeping employees in today’s world is expensive. So is the FUTA mandate for employers to pay state and federal unemployment tax placing an undue burden on American businesses?

In point of fact, the annual cost of unemployment insurance to employers is relatively low. Employers who consistently pay the state unemployment tax are eligible for an offset credit of up to 5.4 percent, independent of the tax rate they pay to the state.

According to the small business resource website, Business Owners Toolkit, the FUTA tax rate is 6.2 percent of taxable wages (wage base is the first $7,000 paid in wages to the employee during the year). After the offset credit is applied, the net FUTA tax rate is lowered to 0.8 percent for a maximum FUTA tax of $56.00 per employee on an annual basis.

How Unemployed Persons File for Unemployment Benefits

On the receiving end of all the complicated tax code is the laid-off worker who files for unemployment benefits. The idea behind this financial cushion is to provide a source of income to bridge the gap until the person is once again gainfully employed.

Unemployment benefits also serve as an economic stimulus to keep people spending into the economy. Unemployment benefits may be paid for up to 26 weeks (6-1/2 months), and may be extended in times of severe economic recession as we see today. People may file for unemployment benefits through the web, by phone, or in person.

In summary, employers pay the IRS a sum of money for each employee in the case of layoffs. This money gets paid back to the employee when he or she files for unemployment benefits. It is for this very reason that every person who is laid off should take advantage of unemployment benefits. After all, the money has been set aside for them for this very situation.

The copyright of the article How Unemployment Insurance Works in Insurance is owned by Daniel Gansle. Permission to republish How Unemployment Insurance Works in print or online must be granted by the author in writing.