If you (like many Americans) are out of work and preparing to collect unemployment benefits, you may be asking yourself, "Do I pay taxes on unemployment benefits?" Ever since the Tax Reform Act of 1986, the answer is yes. In most cases, you must pay taxes on unemployment benefits. Congress decided that unemployment compensation benefits should be treated the same way as taxable wages, since they are technically income. In 2009, the first $2,400 of unemployment benefits was not taxed.
In most states, you can decide whether to have tax payments taken directly out of your unemployment benefits, or to pay the taxes due in a lump sum when you file your income tax. The Treasury Department acknowledges that you may owe a significant amount of money at tax time if you receive unemployment benefits, but notes that these benefits are meant to be a temporary solution to unemployment. However, to help curtail this issue, in 1994 Congress voted to allow unemployment recipients to have income taxes taken out of unemployment benefits in order to avoid a large amount of money due come tax time. If you receive unemployment benefits and do not choose to have taxes taken out directly, you may be required to make quarterly estimated tax payments in some states.
Both state and federal unemployment benefits are taxed. If you received unemployment compensation during the year, you should receive Form 1099-G (PDF) showing the amount of benefits you were paid for the year. This information does not apply, however, for private, unemployment benefits from a fund to which you contribute yourself when you are employed.
US Treasury FAQ: Income, Tax Liability, and Payment, http://www.ustreas.gov/education/faq/taxes/liability.shtml#q3