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For a Tax Season Unlike Any Other, Check These Items Before Your Clients File

The American Rescue Plan includes some significant changes that can affect 2020 tax returns and planning for future years.

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Between the lingering economic impact of the pandemic and the myriad provisions of the newly enacted American Rescue Plan of 2021 and the Internal Revenue Service's decision to push back the tax-filing deadline by a month, this is a tax season unlike any other.

Many advisors are facing unfamiliar situations with clients whose taxes require a second look before sending in those returns. Here are some of the significant changes that can affect 2020 tax returns and planning for future years.

Child Credits and Complications

Under the new law, the child credit has been increased from $2,000 to $3,600 per child up to age 5 and $3,000 for children ages 6 to 17. The new credit is fully refundable (meaning it doesn't have to offset taxes). There is a phase-out for the additional credit in excess of $2,000, beginning at $75,000 for singles and $150,000 for married couples. There is also a phase-out for the first $2,000 of credit, beginning at $200,000 for singles and $400,000 for married couples.

What's also new is that 50% of the credit will be sent to taxpayers in monthly advance payments starting in July 2021. The advance payments are for 2021 but are based on 2020 income. If the 2020 tax return has not been filed, the IRS will base the advance credits on 2019. If the amount advanced exceeds what is allowable on the 2021 tax return, the excess must be repaid. The IRS will release guidelines on how to opt in or out of the monthly prepayments.

Let's say your clients have two children, one age 3 and the other age 10. Assuming the income limitations are not an issue, they would be entitled to $6,600 of child credits. The prepayment amount would be $550 per month from July to December 2021 ($6,600 times 50% divided by 6).

Confusing? Yes it is! We essentially have two credits that have two different phase-out schedules. The rules can be summarized as follows:

  • Adjusted gross income less than $75,000 single or $150,000 married: Entitled to full $3,600/$3,000 per child credit.
  • Adjusted gross income between $75,000 and $102,000 single or between $150,000 and $182,000 married: entitled to $2,000 credit plus phased-out amount of additional credit.
  • Adjusted gross income between $102,000 and $240,000 single or $182,000 and $440,000 married: entitled to phased-out amount of $2,000 credit.
  • Adjusted gross income greater than $240,000 single or $440,000 married: Not entitled to any credit.

Remember that the amount your clients are entitled to depends solely on 2021 income. However, if they want to maximize their prepayment, keep this in mind:

  • If 2019 income is under the thresholds, but 2020 will be higher, delay filing the 2020 return. The IRS will base the prepayment on 2019.
  • If 2020 income is under the thresholds, but 2019 was higher, your client will want to file the 2020 return as soon as possible.
  • No matter what income levels were like in 2019 and 2020, set out now to help your client lower 2021 income to below the thresholds. That's because the child credits are eventually dependent on 2021 income.

Child and Dependent Care Credits

The American Rescue Plan has increased the maximum amount of child and dependent care credits as well expanded eligibility. Previously, the expense limit was $3,000 for one qualifying child or $6,000 for more than one qualifying child. The new limit is now $8,000 for one child and $16,000 for more than one child. (A qualified child is a dependent child under age 13.) The credit is equal to 50% of the expense amount, meaning the maximum credit is $4,000 for one child and $8,000 for more than one child. And, unlike previous years, the credit is refundable. Of course, there are income limitations. 

Instead of the phase-out beginning at $15,000 as it did previously, the credit percentage will phase out as adjusted gross income exceeds $125,000. Thus, starting in 2021, 50% of child care expenses will be allowed in full for taxpayers with an adjusted gross income of $15,000 or less. The percentage reduces ratably to 20% for adjusted gross incomes between $125,000 and $185,000. Then the credit is 20% for adjusted gross incomes between $185,000 and $400,000. The 20% amount phases out at adjusted gross incomes between $400,0000 and $440,000. Thus, for those with adjusted gross income of $440,000 or more, no credit is available.

For 2020, the credit is allowable if your client paid for care in order to work or to look for work. To qualify, the dependent child must be under age 13. The phase-out rules for 2020 are very complex. The credit amount is a percentage of qualifying care expenses based on adjusted gross income. If adjusted gross income is $15,000 or less, the percentage is 35%. To the extent adjusted gross income is over $15,000, the credit percentage is reduced by 1% for each $2,000 (or fraction thereof) above that amount, but not below 20%. For example, someone with adjusted gross income of $21,000 would qualify for a credit of 32% of expenses.

Finally, the child and dependent care credit also covers more than children under age 13. Care expenses also qualify for a spouse who was physically or mentally incapable of self-care and lived with your client for more than half of the year, or for someone else who was physically or mentally incapable of self-care, lived with your client for more than half of the year, and either (1) was your client's dependent, or (2) could have been your client's dependent except he or she received gross income of $4,300 or more. This means that care for an elderly parent can qualify.

There are other requirements and disclosures that must be made on the tax return, so be sure your client works with a qualified tax professional on this.

Maximizing Stimulus Checks

The American Rescue Plan authorized stimulus checks of up to $1,400 per person for those with adjusted gross income of less than $75,000 single or $150,000 married. There's an additional $500 for each dependent age 16 or under. For those earning above these thresholds, there is a ratable phase-out that reaches full disallowance as income reaches $80,000 for single or $160,000 for married. Thus, to maximize stimulus payments, your client will want adjusted gross income to be below $75,000 or $150,000. 

Clients do have some control on how to maximize benefits. Here are three options:

  • If 2019 income is under those thresholds but 2020 will be higher, delay filing the 2020 return. The IRS will base the stimulus check on 2019.
  • If 2020 income is under those thresholds but 2019 was higher, your client should file the 2020 return as soon as possible. Remember that it is possible that you will have to retroactively reduce 2020 income as noted above. (It might already be too late to file "early," but it doesn't hurt to try.) If the payment received is higher than what 2020 would have justified, the excess does not have to be repaid.
  • If income is over the thresholds in both 2019 and 2020, set out now to help your client lower their 2021 income. That's because this round of stimulus checks is actually a prepayment of a credit on the 2021 tax return. Although the client won't get a check now, their 2021 taxes will be reduced by the stimulus amount they're entitled to based on 2021 income.

COBRA Subsidies: Did Your Client Lose a Job?

The new law includes a COBRA "premium assistance" program for workers who qualify for COBRA continuation coverage because of an involuntary termination of employment or reduction of hours. Qualifying individuals will have their COBRA premiums covered in full from April through September 2021. Employers are required to cover the cost and will be fully reimbursed through a payroll tax credit.

To qualify, the individual must:

  • Be eligible for COBRA continuation coverage during any period from April through September 2021;
  • Be eligible for COBRA continuation coverage because of involuntary termination of employment or reduction of hours;
  • Elect or have elected COBRA continuation coverage; and
  • Must not be eligible for other group health plan coverage.

It appears that a former employee may elect COBRA continuation coverage and remain covered without paying premiums until 60 days after the end of the national emergency--at least through September 2021. However, these new rules do not extend the maximum COBRA period of 18 months.

For more detailed information, please refer to the recently released IRS guidelines.

Unemployment Income

Until the new law was passed, unemployment income was taxable for Federal purposes (as well as for many states). Under the American Rescue Plan, up to $10,200 of unemployment benefits collected in 2020 (per person) are exempt from tax. If your clients collected unemployment benefits in 2020, be sure they know to exclude up to $10,200 on their 2020 tax return.

To qualify for the unemployment benefits exemption, a taxpayer must have "modified adjusted gross income" of less than $150,000--whether married or single. For taxpayers with income over that threshold, the only answer is retroactive income reductions. The obvious option is IRA contributions. As long as a qualifying IRA contribution is made by May 17, 2021, income can be reduced by as much as $6,000 per person ($7,000 if over age 55). Note that deductibility depends on earned income, whether or not covered by a company plan and income limits. Self-employment offers other ways to retroactively reduce income. The business can make contributions to a qualified retirement plan or choose to claim accelerated depreciation or expensing on business assets acquired in 2020. As an example, let's say your client has modified adjusted gross income of $76,000 and is subject to the 22% tax rate. Included in this income is $9,000 of unemployment benefits. By making an IRA contribution of $1,001, modified adjusted gross income would be reduced to below $75,000, thus making the $9,000 nontaxable. The Federal tax savings would be $2,222.

What if your clients already filed their tax returns and paid tax on exempt unemployment benefits? They can always file an amended tax return. Filing Form 1040-X will get a refund as long as they file by May 17, 2024. If they file after that date, the right to refund is lost.

This sounds simple, but there are two complications. First, the IRS has asked taxpayers not to file amended returns until it issues guidance on how to do so. In fact, the IRS is recommending those who qualify for the exemption to delay filing their original returns in order to adhere to the upcoming guidance.

Filing an amended tax return must be done on paper (no e-filing) and the 1040-X is not a simple form. If your client already filed the 2020 tax return, there is an alternative to filing an amended tax return as long as it's done prior to May 17, 2021. By simply mailing in a "superseding" return before the due date of the original return, it will replace the original return. This is much easier than filing an amended tax return. If your client decides to go this route, he or she might want to wait until the IRS releases its guidance--here's hoping this happens before May 17!

Be aware that filing a superseding return can come with issues. Because this is a rarely used option, the IRS might mess up and get confused about which return is valid. That could come with notices and delays. So, your client should be sure to keep proof of mailing to document the timely filing of the superseding return.

Final Notes

The American Rescue Plan of 2021 includes numerous and significant law changes, impacting tax laws, vaccine distribution, housing aid, nutrition assistance, education and child care, and small-business relief. Many of the changes require further clarification and guidance. In the meantime, there are several areas that individuals can benefit from, especially with careful planning.

Before your clients file their 2020 tax returns, consider the income limitations for the exclusion of unemployment benefits, the timing of filing for purposes of receiving stimulus money and advance child credits, and qualification for child and dependent care expenses when looking for a job.

Plan now for 2021 to help your clients make the most of stimulus payments, child credits, and child and dependent care credits. And, if any of your clients lost a job, be sure they follow up on free COBRA coverage.

Sheryl Rowling, CPA, is head of rebalancing solutions for Morningstar and founder of Rowling & Associates, an investment advisory firm. She is a part-time columnist and consultant on advisor-focused products for Morningstar, and she continues to actively run her advisory business, from which Morningstar acquired the Total Rebalance Expert software platform in 2015. The opinions expressed in her work are her own and do not necessarily reflect the views of Morningstar or of Rowling & Associates LLC.