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Keep These Things in Mind During Tax Season

2020's not over--at least when it comes to taxes.

Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

Christine Benz: Hi, I'm Christine Benz from Morningstar. We're in the thick of tax season. Joining me to discuss what should be on your radar as you ready your 2020 tax return is tax and IRA expert, Ed Slott. He's the author of a new book called The New Retirement Savings Bomb. Ed, thanks for being here.

Ed Slott: Great to be back with you, Christine. Thanks.

Benz: Well, it's great to have you here. Let's talk about the 2020 tax year. It was an odd year in many ways. I want to talk about some of the dimensions of the CARES Act that it might affect how people approach their taxes for 2020. One is for people with required minimum distributions. They didn't have to take them last year, but some people took them early. What sort of documentation do they have to show to make sure that they're on the up and up with the IRS?

Slott: Well, they don't have to show anything. They have to report what happened correctly. The problem now is people are getting 1099s in the mail. It's exactly as you said. They took the RMD, but then the CARES Act didn't happen till later in March and said, "Now you don't have to take the RMD for 2020, required minimum distribution." So then they put it back, and their advisors or their financial institutions told them, "All right, it's a wash. You're all zeroed out."

So now we're in 2021. They're preparing for their taxes, and they see this 1099-R, which is the form that reports all distributions from retirement accounts. I know this is a problem because the accountants are already calling me. So, let's take an example. Let's say the RMD was $10,000. They took it. They put it back. In their mind, they're square. But now they get this 1099-R--says they owe tax on $10,000. So now they're screaming to their accountant, to their financial advisor, to the banks, "You did it all wrong." The 1099-R is correct. Unfortunately, it only reports, and IRS gets a copy, it only reports the amount out, not that you returned it. Because the financial institutions, they really have no idea what you did with that money. So they're not going to go on the line and put it on a form that it was returned. It's a rollover. You have to do that on your tax return. So either you're doing it yourself or you have a tax preparer. You have to show them or tell them. You have your backup anyway, and you will get backup from the financial institution--you will get a Form 5498, but after tax time, and that doesn't get attached to your return anyway. 

So on your return, you will have to show, in that example, the $10,000 that came out--because you have to match up. Remember, this is all computer matching. There's no one to call to say, "You know, here's what I did," at the IRS. It's all computer matching. You have to match up with the $10,000 as the gross distribution. Then you treat it as a rollover, as a regular rollover when you used to go from, say, one bank to another, or one advisor to another, IRA to IRA. And you write in the word "rollover." I've got to stop saying that. Nobody writes in anything on a tax return anymore. It's all computer-generated. There's a checkbox, an input box, on most tax-preparation programs, or your accountant knows how to do it, that checks that you did a rollover. When you check that box, it's going to print the word "rollover," and if you put back the whole amount, it will print "taxable amount zero." If you didn't put the whole amount back, the amount you didn't put back will show as taxable. So that's how you handle that.

Benz: If someone didn't take an RMD at all, they don't have to provide any of this documentation, right?

Slott: Oh, right, right. Nothing happened, or let's say somebody did take an RMD and spent the money. They needed it. Then everything's like normal.

Benz: How about the hardship withdrawals that people who were affected by COVID were able to take from IRAs or 401(k)s? What type of documentation do they need to provide?

Slott: They have a similar problem, but worse. For most of the financial institutions, they're reporting, I know Fidelity, Vanguard reported about 6%-7% of the people took those distributions. They were only available in 2020. This was the CARES Act. Most of the benefits there ended in 2020, so we were talking about RMDs. They're back in '21. It didn't continue, the waiver. We're still getting those questions. The same thing with the CARES Act distributions, the coronavirus-related distributions. CRDs, another acronym. And you were allowed to take in 2020, no more, if you were affected by COVID either healthwise or income--loss of incomewise--up to $100,000 out. And the benefit was that if you were under 59 and a half, no 10% penalty. Also, you still had to pay tax, but you could spread the income over three years. And if things turned around, you could repay it to eliminate or reduce the tax bill.

So now we're in 2021. The CARES Act is over, but the aftermath, the reporting, is here on your tax return, similar to what we just talked about with the RMDs. Let's say-- another example--you took $60,000. I made a nice, easy number to divide by three. $60,000. And you chose the default. You want to report $20,000 each year for the next three years. Now you've got that 1099. Guess what it's going to show as taxable? All $60,000. So you have to again tell IRS on your tax return, but it's a little more difficult. You have to go to another new tax form for this year, the 8915-E, as in "Ed," 8915-E form to tell them how much of the income you want to report this year, because you could report it all, if you want to make that election. Who would do that? Anybody that had really low income in 2020 and expects their income to increase in '21 and '22, so they don't want to have the income there.

Once you elect, that election is irrevocable. So, you go to this form for two reasons: for the income inclusion to tell the IRS how much you're including as taxable income and to show that the amount you're including, if you're under 59 and a half, is not subject to the 10% early distribution penalty. There's no code to tell the IRS that it's exempt from the penalty. So, if you don't do this extra reporting--or your accountant, I would suggest an accountant in this case, a tax preparer--if you don't do that extra reporting, the IRS is going to think it's all taxable and subject to a 10% penalty because the 1099-R shows it as a normal distribution. You have to give the rest of the story on your tax return.

Benz: The CARES Act also included a small charitable contribution deduction. Let's talk about that and also talk about what aspects of that are carrying forward to 2021.

Slott: Well, anybody who doesn't itemize, which is most people--most people don't itemize anymore because of the larger standard deduction the last few years, so if you don't itemize, you're basically not getting any tax benefit out of your charitable gifts. So, they threw a bone to everybody for 2020. You could deduct $300, even if you're not itemizing, and it reduces adjusted gross income, which is a good deal. For married couples filing joint, the big question was, "Do I get 600?" No. But for 2021, you do. They expanded it. They kept it for '21, allowed married couples to use $600, but then they said, "But we're going to take something back because we just gave you too much." The deduction will not be an above-the-line deduction--will not reduce adjusted gross income. It will only reduce taxable income. So it's not worth as much.

Benz: This is a cash contribution, right? I can't donate...

Slott: Yeah, cash contributions. Exactly. Thank you for clarifying. Yes, absolutely.

Benz: Ed, it's always great to get your perspective. Thank you so much for being here.

Slott: Thanks, Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.