Regulatory and Tax Updates
The 5 Biggest “Tax Gifts” for Individuals in Year-End Package
- Talk with your advisor about how the new laws may affect your income tax planning, cash flow, and financial decisions for 2021.
- In addition, talk with your employer about unused amounts in flexible spending accounts.
Have questions about the recent COVID-19 relief package?
On December 27, 2020, President Trump signed into the law the Consolidated Appropriations Act, 2021. The massive year-end package includes 12 appropriations bills (to fund the federal government through the end of September), enhanced unemployment benefits, a new round of Paycheck Protection Program (PPP) lending, and dozens of provisions targeting businesses and nonprofit organizations that face pandemic-related challenges this year. Similarly, individuals received much-needed stimulus and tax relief. Consider how these surprise “gifts” may affect your income tax planning, cash flow, and financial decisions for 2021.
Second round of stimulus checks
Under the Coronavirus Aid, Relief, and Economic Security (CARES) Act, most Americans received economic income payments of $1,200 ($2,400 for married couples), plus $500 for qualifying children age 16 or younger. For most individuals, the new law provides another round of stimulus payments of $600 ($1,200 for married couples), plus $600 for each qualifying child.
Individuals that passed away during 2020 are eligible. However, parents will not receive any money for older children — nor will the older children receive their own check — if they can be claimed as a dependent by someone else.
The same income limitations from earlier in the year still apply. Taxpayers with adjusted gross income over $75,000 ($150,000 for married couples) may receive smaller amounts or no check at all. However, don’t assume the check is for the “right” amount.
The Treasury Department has no way to know your 2020 income (they will generally use 2019 returns to determine eligibility for a stimulus payment). When you file your tax return, you can claim a higher amount if your check was too low. If you received too much of a stimulus payment — probably because your income increased in 2020 compared with 2019 — you can pocket the extra money. You don’t have to reconcile or pay back any funds.
Help with education costs
The year-end package also includes a few provisions that benefit students and educators:
In response to COVID-19, Congress provided a temporary exclusion of income for certain employer payments of student loans under the CARES Act. The benefit, which was initially limited to payments from March 28, 2020, through December 31, 2020, has been extended through the end of 2025.
To the pleasant surprise of many parents, loans are not limited to the employee’s use. The loan can be incurred by the employee to pay higher education expenses for their spouse or for any dependent of the employee (at the time the loan was incurred). However, the generous benefit is limited since it is grouped with other education-related costs (such as tuition, fees, books, supplies, and equipment) that an employer can pay under a qualified “tax-free” to workers up to $5,250 per year.
Lifetime Learning credit
More families will also receive help with education costs due to higher income limits on the Lifetime Learning credit. This benefit can be claimed for 20% of qualifying expenses (e.g., tuition and fees) up to a credit of $2,000 per year. Beginning in 2021, taxpayers with modified adjusted gross income of $80,000 ($160,000 for married couples) can potentially receive the full benefit. This is higher than the $59,000 ($118,000 for married couples) threshold that applies for 2020, at which point the benefit starts to phase out.
The Lifetime Learning credit — which generally can be taken in the same year as other education benefits as long as there is no “double-dipping” on the same expenses — provides flexibility. For example, it is available to students who were convicted of drug-related offenses and to students taking as little as one course. Most importantly, there’s no limit on the number of years an individual can claim the credit. As the name implies, it can be used for a lifetime of learning.
Qualified emergency financial aid grants
The law clarifies that qualified emergency financial aid grants under the CARES Act are not includible in gross income. While this is not a big surprise, Congress took the relief one step further. Taxpayers who received the nontaxable income are able to retain any American Opportunity Tax Credit and/or Lifetime Learning credit for which they would have otherwise received1. This “double-benefit” is a welcome relief for students who face hardships related to COVID-19. For other nontaxable educational assistance, such as scholarships, a taxpayer generally must reduce their amount of eligible tuition and related expenses in calculating education credits.
Educator tax breaks
The law also provides a small tax break for educators (kindergarten through grade 12). Teachers, aides, counselors, principals, and other eligible educators can generally deduct up to $250 of work-related expenses from their gross income (even if they take the standard deduction). For expenses paid or incurred after March 12, 2020, personal protective equipment and other supplies related to the prevention or spread of COVID-19 will qualify under this deduction.
Postponement of certain payroll tax obligations
President Trump issued a presidential memorandum in August 2020 that directed the Treasury Department to postpone certain payroll tax obligations in light of the ongoing pandemic. Some employers seized the opportunity to delay the withholding of their employees’ share of Social Security taxes, which temporarily boosted their take-home pay by 6.2%.
Employees could only benefit from the payroll tax holiday — from September 1, 2020, through December 31, 2020 — if their bi-weekly paycheck, calculated on a pre-tax basis, was less than $4,000 per week (or less than $104,000 annually). The year-end bill allows employees to pay back the withholding throughout next year without any penalty or interest (as opposed to catching up on payroll taxes in the first few months).
Congress also granted “more time” to flexible spending arrangements (FSAs). FSAs allow employees to pay medical and dependent care expenses pre-tax (income tax and FICA). An individual can contribute up to $2,750 to a health FSA and $5,000 for dependent care. However, there’s a catch — you must generally incur the expenses by the end of the year or you lose it (it’s appropriately called the “use-it-or-lose-it” rule). Some employers offer a grace period through March 15 of the following year, but the IRS won’t allow anything further.
That’s a tough “penalty” for 2020 when circumstances are completely unexpected and out of the worker’s control. Many individuals were forced to delay medical and/or dental procedures due to state mandates, facility prioritizations, or out of concern for catching COVID-19.
Parents faced similar challenges with dependent care. With the shift to virtual, many areas lacked after-school programs and summer camps. Instead, parents took off work to take care of children. For one or more of these reasons, many workers did not incur the medical and/or dependent care expenses they were anticipating, and as a result potentially left significant amounts in their FSAs at the end of the year. The new law temporarily permits employers to modify plans to allow participants to rollover unused benefits from 2020 to 2021, and 2021 to 2022 (in other words, a 12-month grace period). The bill also authorizes plans that allow employees to make mid-year changes in their election amounts in 2021. Talk with your employer since you may benefit from one or more of these “gifts.”
EITC and child tax credit flexibility
Many individuals typically claim the earned income tax credit (EITC) and/or child tax credit, but it may be challenging to have sufficient earned income this year to obtain the benefit. Consider the following:
- The EITC is a refundable credit for lower-income workers, up to $6,660 in 2020. Whether an individual qualifies for the EITC and the amount of the credit generally depend on (1) the amount of your “earned” income and (2) whether you have related children living with you. The credit (ranging from 7.65% to 45%) is applied to your earned income to calculate the credit. If you do not have any earned income, you will not receive any benefit. There are other restrictions as well.2
- The child tax credit is currently up to $2,000 per qualifying child under age 17. A portion of the credit is refundable based on several factors, including whether and to the extent that your earned income exceeds $2,500. This restriction is important because if you do not have sufficient earned income, you may receive a limited benefit or no benefit at all. Nonrefundable credits can only offset taxes — you cannot receive a check in the mail for the leftover amount.
Due to COVID-19 shutdowns and economic uncertainty this year, many individuals faced temporary or permanent layoffs. Their financial support was limited to unemployment compensation and/or economic stimulus payments. Unfortunately, neither of these items are considered earned income.
In order to help individuals who typically claim these credits — both of which rely on an individual receiving earned income — the new law provides a special rule for 2020: a taxpayer may elect to use their 2019 earned income amount (as opposed to 2020) to calculate their EITC and child tax credit benefits if their income dropped in 2020.
More certainty on several provisions
The year-end package offers individuals some certainty regarding several provisions that were set to expire at the end of the 2020. The earlier Congress addresses these frequently renewed “tax extenders” during the year, the more opportunity for informed tax planning and financial decisions.
Tax breaks now available through the end of 2021 include:
- Charitable contribution deduction up to $300 for individuals ($600 for married couples) that do not itemize their deductions
- Higher limit (up to 100% of modified adjusted gross income) for charitable contributions of cash to public charities when itemizing deductions
- Inclusion of mortgage insurance premiums as qualified mortgage interest
- Refundable health coverage tax credit (on COBRA continuation coverage, certain state-based programs, etc.)
- Energy property credit for certain energy efficient improvements to your home
- Credit for the construction of energy-efficient new homes
- Credit for two-wheeled plug-in electric vehicles
Other provisions were extended longer. The residential energy-efficient property credit and inclusion of biomass fuel property expenditures now expires at the end of 2023. The exclusion from gross income on loan forgiveness related to your principal residence (second homes do not qualify) will continue for another five years. However, the $2 million limit was reduced to $750,000 for loans forgiven after December 31, 2020. Finally, the medical expense deduction for expenses in excess of 7.5% of adjusted gross income (which would have increased to 10%) is now permanent.
How we can help
If you have additional questions about the Consolidated Appropriations Act, 2021, our team can help you navigate its complexities. Our goal is to understand your specific needs, interpret how legislation impacts you and your family, and create a strategy to help you reduce your tax burden.
1This provision effectively overrides IRS FAQs issued on May 7, 2020.
2For example, the credit is reduced for income over certain levels (ranging from $7,030 to $14,800, again depending on the number of children living with you) and completely unavailable if you have investment income (such as interest, dividends, and capital gains) over $3,650 for 2020.