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How to Get COVID Financial Relief When Filing Your Taxes
The impact COVID-19 had on 2020 was immense. Hundreds of thousands of Americans lost their lives, and many more felt the grief from those losses. Illness, job loss, cut hours — and almost everyone suffered the loss of social connection and routines we once enjoyed.
Even though most Americans received two stimulus payments in 2020 to help out (and those are thankfully tax free), the loss of work and income led people to difficult financial choices.
As tax season rolls around and people file taxes on their 2020 income, there are actually many opportunities to make a little bit of lemonade out of the lemons of 2020. For people in some situations, 2020 provides tax benefits that may result in a much larger refund check than expected.
Tax benefits if you tapped your 401(k) in 2020
In a normal year, withdrawing funds from your 401(k) before you are 59 1/2 years old incurs an additional 10 percent penalty on top of the taxes you have to pay on that money. However, in 2020, the federal CARES Act waived that penalty for up to $100,000 in withdrawals. Not only that, this money could be recognized as income over a three-year period, and you can also replace that money over a three-year period without any tax penalty. The IRS provides clear answers to questions related to this in its CARES Act FAQ.
So, what does this mean if you withdrew money early from your 401(k) in 2020? Let’s say you withdrew $30,000 in order to survive the year. In an ordinary year, you would have to treat this as ordinary income, pay income taxes on it, and pay an additional 10 percent penalty — another $3,000.
For 2020, however, you have more options. You don’t owe that 10 percent penalty at all. You could choose to spread that income across three years if you like, reporting $10,000 on your return this year, the next year and the year after. Furthermore, if you decide to repay that $30,000 by the end of 2022, you can file an amended return for the earlier years and claim a refund on the taxes you paid on the $10,000 for each year.
Opportunity to get any stimulus checks you may have missed
If you were eligible to receive stimulus money in 2020 (referred to by the iRS as an Economic Impact Payment), and you didn’t receive all of it, don’t fret. You can claim the missing amount as a Recovery Rebate Credit on your taxes that you file this spring, which will reduce the taxes you owe by the amount you’re still missing from your stimulus payment. This means that you’ll essentially receive your payment as part of your tax refund (or in the form of a smaller tax bill, in some cases).
The IRS addresses most questions you may have about this on their Recovery Rebate Credit page.
Potential eligibility for the Earned Income Tax Credit
Some people who experienced a drop in income in 2020 may now be eligible for the Earned Income Tax Credit, which is a direct reduction in your tax bill that applies to lower-income households, particularly those with children.
As a quick check, if you earned $55,000 or less in household income in 2020 and have three or more children, you’re likely eligible for the credit. For fewer children, the income limit drops significantly, down to $47,000 in household income for one child and just $21,000 if you don’t have any. The IRS EITC Fast Facts page explains the basics.
What’s the benefit of this credit? The size of the credit ranges to as high as $6,660 (if you have three or more qualifying children). For many people, that becomes a direct boost to their tax return, or can turn a situation where they owe taxes into a situation where they get a refund instead.
What if you receive a large tax refund?
These factors combined may lead you to receive a larger-than-usual tax refund this year. If you’re due to receive a big check from the IRS, be smart with your tax refund. Here are some things to consider.
Pay off high interest debts. If 2020 saw you racking up credit card debt or payday loan debt, your income tax refund check should be used to eliminate some or all of that debt. Start by constructing a debt repayment plan (it’s easy!) and use that to determine which of your debts you should pay off first.
Start an emergency fund. If you don’t have any outstanding high interest debts, consider putting some of the money aside in an emergency fund. An emergency fund is just what it sounds like — a reserve of cash hidden away for emergencies. Building an emergency fund isn’t hard, especially if you start with a bit of cash.
Save for a known upcoming expense. If you know that an appliance will have to be replaced soon or a car will need to be upgraded soon, hold onto that cash for a while until it’s time to make that big purchase. Having a down payment — or enough to pay for the whole thing — will save you quite a lot compared to having to use credit or take out a loan.
Bad news: you do owe taxes on unemployment… but there’s help
If you received unemployment benefits in 2020, bad news: You do owe income taxes on those benefits, just like you do on ordinary income. Don’t worry if you’re in this situation, however: If you elected to have taxes taken out of your unemployment checks, you’re in good shape.
What if you didn’t do that? First, prepare your income taxes and see how much you owe. Start saving as much as possible as soon as possible so you can afford the tax bill. Next, be proactive and contact the IRS directly to set up a payment plan.
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