President Biden signed the American Rescue Plan into law on Thursday, March 11, 2021. The law provides $1.9 trillion of tax and financial relief to businesses and individuals and includes a provision that makes a taxpayer’s first $10,200 of unemployment compensation (UC) non-taxable at the federal level. Many taxpayers who were waiting to see if this provision was included in the final law can now file their tax returns but some may want to continue to wait.
The IRS issued guidance for how to account for the new law on an individual 1040 on Friday, March 12. The adjustments can be made manually, but it is probably best to wait to file—at least until software vendors have had the opportunity to implement and test the change and to push it out to users. The new law can result in changes to adjusted gross income (AGI), which is used in calculations and thresholds for many items on a tax return, not simply the tax. Making a manual adjustment could result in some benefits getting overlooked. Taxpayers who prepare their own returns using software should remember to ensure the necessary update is installed and recalculate their returns before e-filing.
Another reason to wait to file is that it remains unclear how many states will follow the new federal law. Many states are in desperate need of tax revenue and may decide not to exempt that first $10,200 from state income tax. If you live in a state with no state income tax it is probably safe to go ahead and file your individual 1040. If your state taxes income it is best to wait until your state issues guidance as to whether or not they are following the federal law. If you file a joint return with your spouse, even in a state with no state income tax, keep reading. Taxpayers whose joint AGI exceeds $150,000 may need to review whether filing separately is a better option this year.
Married taxpayers who received unemployment but whose joint AGI exceeds $150,000 should consult their tax professional to determine if filing separately provides a better tax result than a joint return. Up to $10,200 of UC per spouse is exempt from federal income tax under the new law, but once the AGI for a return exceeds $150,000 all UC is taxable. Filing separately could help one or both married taxpayers avoid this cliff. Nevertheless, filing separately may not be the best answer depending on various tax credits, whether or not the taxpayers live in a community property state, and a variety of other factors. If you are working with a tax professional be aware that to provide a comprehensive married filing separately analysis takes time and effort. Many tax professionals charge for both the analysis and for the second return. Additionally, your tax professional may request (or insist) that you file for an automatic extension to provide them with the time necessary to fully analyze the benefits and costs of filing separately. The tax benefits of non-taxable unemployment can range from $1,000-$,2000 but the tax costs of losing, for example, education credits can also be thousands of dollars. In general, it will be worth both the extra expense and the extra time required to let your trusted tax professional do the analysis and provide a recommendation based on your specific facts and circumstances.
One important aspect of tax law that taxpayers should be careful not to overlook is that taxpayers may not amend a jointly filed return to file separately. Tom Gorczynski, Enrolled Agent owner of Gorczynski & Associates a tax preparation and planning firm in Phoenix, Arizona, notes that married taxpayers who have already filed a joint return can still get relief by filing a superseding return before the April 15 filing deadline. The mechanics of filing a superseding return are well beyond the scope of this article but a superseding return is an option for undoing a jointly filed return if you act quickly.
This impending deadline for filing superseding returns is one more reason taxpayers who have not yet filed should be prepared to file an extension if they want their tax professional to evaluate the possible benefits of filing separately. Many tax professionals are currently working on superseding returns for clients whose joint returns have already been filed. Superseding returns for clients who need them will be taking priority over unfiled returns in the short term. And if you’re worried that filing an extension increases your risk of an audit, that is a common tax myth but it is only a myth.
You may be thinking, “I don’t want to wait. Can’t I file now and amend later?” Yes, other than amending a joint return to file separately (which is not allowed) you can file now and amend up to three years later to claim an additional refund. If you are expecting a large federal refund that has been made larger by this change and you need that money now, filing now and amending later may be your best option.
Keep in mind, however, that while amended returns can now be filed electronically (if the original return was filed electronically) they are often processed by hand and getting your additional refund could take a few months, or longer. The IRS is catching up on processing 2019 paper-filed returns but remains behind on other correspondence and has now been tasked with distributing the third round of Economic Impact Payments and will be working on advanced payments of the Child Tax Credit soon. If you plan on filing an amended return be prepared to wait for your money.
If you use a tax professional also be aware that most of tax practitioners charge for preparing and filing amended returns and that they may not be able to work on your amended return until after the April 15 filing deadline. At this time it remains unclear whether filing an amended return will even be necessary to get the benefits of the new law. It is still possible that the IRS could implement software changes later this year that would make the adjustments and issue notices and refunds automatically. In the event that happens it is still a good idea for taxpayers to review any IRS notice they receive with a tax professional to ensure that it is correct and that other beneficial changes to reduced AGI have not been overlooked.