With tax season opening and the IRS accepting returns this week, I figured it is timely to talk through some of the most common situations and questions I have been running into as an Enrolled Agent. Let’s get right into it.
Question 1: Stimulus payment
You will report both of the stimulus payments on your 2020 return - even the second payment that was received in 2021. These payments are considered an advanced payment of a new refundable tax credit in 2020 called the Recovery Rebate Credit. Here are the common questions along with this:
- Is this taxable income? No, it is not reported as income but a refundable credit, which means it lowers your tax liability or increases your tax refund dollar for dollar. If you received the full amount for both stimulus payments, there will be no effect on your return.
- What if I didn’t get the full amount? The distributed payments were based on your 2019 tax return (as a way to determine who to pay), but the credit is based on your 2020 taxes. If your 2020 tax return has a lower adjusted gross income than your 2019 return that makes you eligible for the full payment (or a bigger payment than you received), you will report the difference via the Recovery Rebate Credit, which will be added to your refund (or lower your tax due).
- I made MORE money in 2020; do I have to pay it back? Nope, there is no claw back.
Question 2: Retirement account withdrawals
I have seen many 1099-R statements this year, which report distributions from a retirement account. Many individuals this year made a withdrawal from their retirement accounts as a COVID distribution (note, this is not talking about a 401(k) loan, but a distribution). If you were affected (physically or financially) by COVID and you took a retirement distribution in 2020, then you should be able to avoid the 10% early withdrawal penalty. Taking the distribution DOES NOT exclude taxes on the distribution; you still need to recognize the full amount as ordinary income (assuming it is all pre-tax money). COVID allows you to avoid the penalty, not the tax.
The IRS still has not finalized the form that will enable you to report this, so I recommend waiting to file your return until this comes out (it will be called Form 8915-E). On top of waiving the 10% penalty, the form also allows you to choose one of the following:
- Recognize the full taxable amount as income on your 2020 taxes, OR;
- Recognize the full taxable amount equally over 3 tax years with the same amount in 2020, 2021 and 2022. This will take a bit more tracking and reporting, but may allow you to pay less tax over the three years.
You also have up to 3 years to pay your distribution back if you choose. If you are planning on doing this, it does not change your reporting until you pay it back. You still have to report the income, and if you pay it back then you can amend prior tax returns as needed. It is not required to pay this distribution back.
I have heard some say “they already withheld the taxes so I may as well recognize the full amount in 2020”. Just because they withheld taxes, doesn’t mean it is theirs to keep. You can still get that back in your refund if you only report one third of the distribution (and you overpaid taxes). Run the numbers to see what makes the most sense for your situation.
Finally, the rules above have to do with your Federal tax return. It is still up in the air what is going to happen with state jurisdictions, and if they will adopt or decouple from the Federal tax rules. Be sure to review your state's tax laws on how to best report this for your situation.
Question 3: State tax issues
State taxes can get very tricky, and I am not a master in every state, but there are some common themes among the states. You’ll notice I say typically a lot and that’s because again, I do not know every state income tax law, so make sure you research your own state to understand how this works. This section is for either people who lived in two different states within the year or those that lived in one state but worked in another.
If you lived in two states in 2020, make sure you review your returns to ensure you are not double counting your income. Typically, states only require you to report the income you received while you were living in that state. Your W-2 should split your wages correctly between the two states (assuming you made the changes to your payroll company during the year).
If you lived in one state and worked in another, there are typically two ways that states handle this:
- Reciprocity: some states have a reciprocal agreement, which means you only have to pay taxes in the state you live. If you live in Kentucky and commute to Illinois to work, you should have KY income taxes withheld and you shouldn’t even file an IL return. If IL taxes are withheld, you will have to file a nonresident return to get that money back.
- If there is no reciprocity, you have to report the income on both state returns. But your home state typically gives you a “credit for taxes paid to other states” for the income tax paid. If KY and IL did NOT have a reciprocal agreement in the scenario above, you would file a nonresident IL tax return for the income you made there. You would report all income on your KY return then report taxes paid to IL as a credit on your KY return which would reduce your KY tax liability dollar for dollar (assuming KY taxes were the same or more than IL taxes. You get a credit for other state taxes paid UP TO the amount of tax your home state assesses on that income). This ensures that two states are not taxing you on the same income.
One small point in the above scenario is that this is for state taxes, not local taxes (omg how many jurisdictions??). If you commuted from KY to Chicago, IL to work (just a 6 hour drive each way, makes sense) then KY does not have reciprocity with Chicago; you would still have to pay that local tax which would typically THEN be reported as a credit for taxes paid on your KY return.
Although this can get confusing, this is all to say pay attention to ensure you are not getting double taxed. Review both state returns when you are finished preparing your returns and make sure that all income is reported, but not over reported.
Question 4: Self-employment income
A lot of individuals have picked up side jobs, short gigs, part time work, etc. to get some extra money during the pandemic. This would have been beneficial for cash flow, but may add some tax complication. Nothing you can’t handle! A few things to pay attention to:
- You are responsible for self-employment tax. This is also called payroll or FICA tax that must be paid on all wages. You will owe 15.3% on these self-employment wages (assuming you had less than $137,700 in wages, but more than $400 in self-employment). This is before adding this income to your Federal and state tax returns.
- You may also be eligible for the Qualified Business Income Deduction on your Federal return which is available for many self-employed individuals. I’ve seen some individuals concerned over this saying “does the IRS think I am a business? Will that add scrutiny?” – no, it’s just what the deduction is called.
- You will have to file a Schedule C most likely, and this is where you will report any expenses involved with your self-employed income. Don’t be surprised if tax software or a tax preparer charges you extra to add a Schedule C.
Question 5: Tax deductions as an employee
I have gotten many questions related to this topic, and the main question this year specifically was: “I worked from home a lot, can I deduct my expenses / home office?” For the majority, the answer is no. The only individuals that can utilize these deductions are those with the job title of Armed Forces Reservist, Qualified Performing Artist, Fee-Basis State or Local Government Official, or an individual with a disability claiming impairment-related work expenses.
This used to be called an “unreimbursed employee expense” deduction on Schedule A, but the Tax Cuts and Jobs Act eliminated this a few years ago. If you are considered an employee and receive a W-2, you cannot claim any expenses as a deduction (unless your job title is above). Your best bet is to try to go to your employer and ask them to reimburse you (since they could claim this as a business expense).
Again, these rules are for your Federal tax return; there are some states that may allow unreimbursed employee expenses as a deduction. Make sure you review this for your state before assuming your state follows the Federal rules.
I have also received many questions about who gets to claim what. Rarely does the tax law let you have a choice as to how you want to report something. Pay attention to timing, who is legally responsible for expenses, and who is actually paying the expenses that can be claimed as a deduction. Some examples I have run into:
- If you took a retirement distribution, you have to report that on the state return in which you lived when you took the distribution. If you lived in two states, you can’t choose to report the income in the state with the lower tax rate.
- If you own a house with an unmarried individual, you do not get to choose who takes the deductions. It is based on both who is legally responsible for the expenses as well as who actually paid the expenses.
- Children can get tricky, but generally you do not get to choose the parent who claims all the benefits (in the event of separation). There is one custodial parent who gets everything; they may be able to choose (or be required per a separation agreement) to allow the noncustodial parent to claim the child tax credit, but you cannot transfer the Earned Income Credit or the Head of Household filing status (nor do you both get it if there is one child).
- Finally, you do not get to claim your adult child for the tax benefits; if they support themselves, they must file their own tax return.
Taxes do not have to be scary! This may feel like a lot, but the technology out there today should help to guide you through many of these situations. That being said, we cannot solely rely on technology. Reviewing your situation will help you to both understand the benefits you are receiving (or can receive throughout the year) and feel confident with what you are filing.
Best of luck this tax season!