A credit reduction on Form 940 is an increase in the federal unemployment tax you owe because your state has an unpaid loan from the federal government’s unemployment trust fund. Normally you pay an effective FUTA rate of 0.6% on the first $7,000 of each employee’s annual wages, thanks to a 5.4% credit for paying state unemployment taxes on time. When your state is on the credit reduction list, part of that 5.4% credit is taken away, and the extra tax you pay goes toward repaying the state’s federal loan.
How FUTA Normally Works
Federal law imposes a 6.0% unemployment tax on the first $7,000 you pay each employee during the calendar year.1Office of the Law Revision Counsel. 26 USC 3301 – Rate of Tax Employers who pay their state unemployment taxes on time get a credit of up to 5.4%, dropping the effective federal rate to 0.6%.2Internal Revenue Service. FUTA Credit Reduction A credit reduction chips away at that 5.4% credit, so the effective rate you pay rises above 0.6%.
Why States End Up on the Credit Reduction List
When unemployment claims spike, state trust funds can run dry. States in that spot borrow from the federal government under Title XII of the Social Security Act to keep benefits flowing.3Office of the Law Revision Counsel. 42 USC Chapter 7, Subchapter XII – Advances to State Unemployment Funds If a state still has an outstanding loan balance on January 1 of two consecutive years and hasn’t fully repaid it by November 10 of that second year, employers in the state lose part of their FUTA credit.4Office of the Law Revision Counsel. 26 USC 3302 – Credits Against Tax
The reduction applies uniformly to every covered employer in the state. Your own experience rating and claims history don’t matter. If your state qualifies, you pay more.
How Much the Credit Is Reduced
The reduction starts at 0.3% of taxable wages in the first year a state qualifies. Each additional year the loan remains unpaid, the reduction grows by another 0.3%.2Internal Revenue Service. FUTA Credit Reduction The progression looks like this:
- Year 1: credit drops from 5.4% to 5.1%, effective FUTA rate rises to 0.9%
- Year 2: credit drops to 4.8%, effective rate rises to 1.2%
- Year 3: credit drops to 4.5%, effective rate rises to 1.5%
Starting in year three, additional penalties can layer on top of the base 0.3% step if the state’s average employer contribution rate falls below certain thresholds. A steeper add-on kicks in at the fifth consecutive year, tied to the state’s benefit cost rate.4Office of the Law Revision Counsel. 26 USC 3302 – Credits Against Tax Those layered add-ons are how the U.S. Virgin Islands reached a 4.5% credit reduction for 2025, well beyond what simple 0.3% annual steps would produce.
Which States Have a Credit Reduction
The Department of Labor publishes the final list of credit reduction states each year after the November 10 repayment deadline.5Employment and Training Administration – U.S. Department of Labor. FUTA Credit Reductions For tax year 2025, two jurisdictions carried reductions: California at 1.2% and the U.S. Virgin Islands at 4.5%.6Federal Register. Notice of the Federal Unemployment Tax Act (FUTA) Credit Reductions Applicable for 2025 Connecticut and New York also had outstanding advances entering 2025 but repaid before the November 10 deadline and avoided the reduction.
For 2026, several jurisdictions had outstanding Title XII loan balances as of early March, including California (roughly $21.8 billion), the Virgin Islands (about $19.8 million), Connecticut (about $4.5 million), and Texas (about $27.1 million).7U.S. Treasury Fiscal Data. Advances to State Unemployment Funds (Social Security Act Title XII) Carrying a balance early in the year doesn’t guarantee a credit reduction, since a state can repay before November 10. Given the size of California’s balance, employers there should plan for a likely increase to at least 1.5% for 2026.
Calculating What You Owe
The math is straightforward. Multiply your FUTA-taxable wages in the affected state by the credit reduction percentage. Only wages up to $7,000 per employee count.
Take an example. You operate in California and paid 10 employees the full $7,000 in FUTA-taxable wages during 2025, when California’s reduction was 1.2%. The extra tax is $70,000 × 0.012 = $840. That sits on top of the $420 you already owe at the standard 0.6% rate ($70,000 × 0.006), bringing your total FUTA liability to $1,260.2Internal Revenue Service. FUTA Credit Reduction
p>If you operate in multiple states and only some are on the list, the additional tax applies only to wages paid in the affected states. Wages paid elsewhere stay at the normal 0.6% effective rate.
Reporting the Credit Reduction on Schedule A
The credit reduction is reported on Schedule A (Form 940), which lists every state and territory with the applicable reduction rate pre-printed for the current tax year.8Internal Revenue Service. About Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return Fill in only the states where your employees worked.
For each credit reduction state, enter the total FUTA-taxable wages you paid in that state during the year and multiply by the state’s rate in the box Schedule A provides. If you have employees in more than one credit reduction state, repeat for each. Add up all the reduction amounts and enter the total at the bottom of Schedule A.9Internal Revenue Service. 2025 Schedule A (Form 940)
Transfer that total to Line 11 of Form 940, where it gets added into your base FUTA tax calculation.10Internal Revenue Service. Form 940 for 2025 – Employer’s Annual Federal Unemployment (FUTA) Tax Return Attach Schedule A to Form 940 when you file. Make sure taxable wage figures on Schedule A match your payroll records; mismatches invite IRS notices. For multi-state employers, getting the state-by-state wage allocation right is where most Form 940 disputes with the IRS start.11Internal Revenue Service. Employment Tax Recordkeeping
How the Credit Reduction Affects Your Deposit Schedule
Form 940 is annual, but you may owe quarterly FUTA deposits during the year. The trigger is $500: if your accumulated FUTA liability exceeds $500 for any quarter, including amounts carried forward from earlier quarters, you must deposit that tax by the last day of the month following the quarter’s end.12Internal Revenue Service. Topic No. 759, Form 940 – Filing and Deposit Requirements If your total FUTA liability for the year is $500 or less, you can skip quarterly deposits and pay the full amount with Form 940.13Internal Revenue Service. Employment Tax Due Dates
This is where the credit reduction sneaks up on smaller employers. An employer who normally stays under the $500 quarterly threshold at 0.6% may cross it once a credit reduction applies. Run the numbers early in the year if your state is a potential candidate, so you don’t miss a deposit deadline and pick up penalties on top of the higher tax bill.