Greg Rosica, CPA, CFP, a partner with the accounting firm Ernst & Young who specializes in private client services and tax consulting, New York City. EY.com
A year ago, it looked like 2020 would be an uneventful year for taxpayers, with little new expected to come out of Washington that would have much effect on them. But in the final weeks of 2019, Congress managed to pass far-reaching legislation called the SECURE Act, affecting retirement plans and education savings plans, and it had an array of effects on taxes. Then, within months, coronavirus-induced shifts in daily life and massive economic stimulus legislation to fight the recession caused by the pandemic also had tax implications.
In the wake of those immense changes, here’s what you need to know to make sure your year-end 2020 tax planning helps you get the most out of tax breaks and avoid penalties…
Economic Relief Payments
Some of this year’s massive corona-virus-relief payments are not taxable, while others are. They came in two forms—economic stimulus payments automatically sent to tens of millions of people who were below certain income levels…and subsidies boosting unemployment benefits. You don’t pay tax on the stimulus payments because the IRS does not consider them to be income. If you earned too much in 2019 to get a payment but your 2020 income is low enough to qualify, you still can get a stimulus payment. Once you file your 2020 income taxes, you will receive it as a refund.
In contrast, most unemployment money is subject to federal tax—and state tax, in many cases—which could lead to a surprisingly large tax bill.
What to do: If you’ve been receiving unemployment benefits, find out how much is taxable at IRS.gov/help/ita/are-payments-i-receive-for-being-unemployed-taxable. Opt to have federal income tax withheld. Otherwise, start putting aside adequate funds to cover your 2020 tax bill next year.
Retirement Account Loans and Withdrawals
The pandemic resulted in so much financial hardship that the Coronavirus Aid, Relief and Economic Security (CARES) Act included a provision allowing certain individuals to take up to $100,000 worth of early distributions from non-Roth IRAs and traditional 401(k) and other similar defined-contribution plans through the end of 2020. They could avoid the 10% penalty for people under age 59½ if they have experienced coronavirus-related job loss or illness. (You still have to pay personal income taxes on the distributions).
Recently, the IRS expanded who qualifies to take these distributions and clarified the tax circumstances if you treat them as loans. You now can qualify for a penalty-free distribution as long as you, a spouse or a dependent has suffered “adverse financial consequences” from the pandemic. That could include being furloughed or reduced to part-time work…losing freelance work…or having a job offer rescinded or delayed.
What to do: Drawing on retirement accounts when you still are in your working years generally is not a good idea. However, if you really need the money, you can take up to $100,000 in penalty-free distributions if you designate the withdrawals as coronavirus-related distributions on your income tax returns for the year. You can spread the distributions evenly over three years (2020, 2021 and 2022) for tax purposes.
If you want to take a distribution as a loan and repay it so you don’t lose too much ground in saving for retirement, you have three years to return part or all of the loan to your retirement account. If any of the money is replaced within that period, you can file amended returns to recoup the taxes paid.
Normally, to deduct charitable donations, you must itemize deductions on your income taxes instead of taking the standard deduction. But the CARES Act provided increased tax incentives for charitable giving, allowing you to donate and save on taxes at the same time.
What to do: Even if you take the standard deduction, the law allows you to make a cash donation in 2020 to a nonprofit of up to $300 per tax return and deduct it against your 2020 income. If you itemize deductions on your tax return, you aren’t subject to the $300 limit for charitable contributions. In that case, you can elect to deduct cash contributions made this year up to 100% of your adjusted gross income, up from the usual 60%. This change is available only for tax year 2020 unless Congress extends it.
Many millions of Americans have shifted to working from home, ratcheting up spending on supplies and other necessities. Some, but not all, of those workers may qualify for hundreds or even thousands of dollars in deductions on personal income taxes for those expenses.
Who qualifies: Small-business owners and self-employed individuals who have started to or continued to work from home. The work space must be the principal place of business and used exclusively for business purposes. But employees on payroll who receive W-2 tax forms are not eligible, even if their companies’ offices have been closed. Resource: See IRS publication 587, Business Use of Your Home, to figure out whether you can take deductions for the business use of your home and what is allowable.
What to do if you don’t qualify: Ask your employer to cover your out-of-pocket expenses. Some states including California, Illinois and New Hampshire have enacted legislation that requires companies to reimburse employees for reasonable and necessary out-of-pocket work costs.
Also, if you plan to continue working from home even after your company reopens its offices, check with your accountant and human resources department about whether it’s possible to be paid as a “pass-through entity” instead of staying on the payroll. Many small-business owners and freelancers operate as pass-through entities by filing taxes as sole proprietorships. The net income from such businesses is passed through the business and taxed on the owners’ individual tax returns at their individual tax rates. The IRS allows most pass-through business owners to take a 20% deduction on their taxable income. For instance, if your total annual income puts you in the 22% federal income tax bracket, you pay the 22% rate on 80% of your income and no tax on the rest. Important: Becoming a pass-through entity could disqualify you from employee benefits such as health insurance and/or participation in 401(k) plans.
529 College-Savings Plans
How educational institutions choose to operate this fall can cause potential tax snafus for those who made 529 withdrawals in 2020. Money withdrawn from these plans is tax-free if used to pay for college tuition and other qualifying expenses. However, some colleges have switched to remote learning and are giving partial tuition refunds to families. If you used money withdrawn from a 529 plan to pay tuition, those refunds now may be regarded as nonqualified, triggering tax on the earnings portion and potentially a 10% penalty for early withdrawal. What to do…
Replace any money refunded by the college that you took from the 529 plan account within 60 days of the date of the refund, either in the same account or a different one with the same beneficiary.
Spend the refunded money on qualified expenses such as a new computer or Internet access to help the student take online classes.
Use the refund to pay down student loans. The SECURE Act allows 529 plan holders to withdraw up to $10,000 tax-free to put toward their own student loan debt or that of their children, grandchildren or spouses.