In the next few weeks, the Internal Revenue Service (IRS) will begin accepting federal tax returns for the 2020 tax year. The coronavirus pandemic and multiple pandemic-related relief packages passed last year will make the tax season unique for taxpayers and for the IRS.
Congress introduced several tax policy changes in 2020 that will impact the upcoming tax season, including through the CARES Act passed in March 2020 and the coronavirus relief package passed as part of the Consolidated Appropriations Act, 2021 in December. Because of the changes, the tax filing season will have several unique features to keep in mind: the adjustment of economic impact payments on individual income tax returns, the taxation of unemployment insurance (UI) benefits, and changes to individual tax refunds.
Under normal circumstances, the IRS usually begins the tax season in late January. The IRS is expected to open the tax season without a significant delay, though the agency is urging taxpayers to file their returns electronically this year to expedite the processing of tax returns.
Economic Impact Payments
The IRS and Treasury Department sent two rounds of economic impact payments to individuals in 2020 as part of broader coronavirus relief packages. The payments, sometimes called stimulus payments, were sent through direct deposit, paper check, or prepaid debit cards. Technically, the payments are tax credits advanced to individuals based on their 2018 or 2019 adjusted gross income (AGI). For the filing season about to begin, the IRS updated the 2020 Form 1040 to finalize payments in case individuals are eligible for an additional amount.
Individuals may receive an additional payment (in the form of a refundable tax credit on their 2020 individual income tax return) in one of two ways. First, filers who did not receive either of the payments due to processing delays or errors may claim it on their return.
Second, filers will use 2020 AGI when calculating any credit they are owed. If a filer received a partial payment (or no payment at all) because the filer had a 2018 or 2019 AGI above the phaseout threshold, the filer may claim an additional payment if they had a lower 2020 AGI that would make them eligible for an additional payment. Filers who did not receive a payment for an eligible dependent may also receive the credit on their tax return. Additionally, filers who originally were not eligible for a CARES Act payment because they lacked a Social Security number may be eligible if they are part of an eligible mixed-status family.
Adjustments are only made in the taxpayers’ favor, so taxpayers will not see any increase in their tax liability related to the payments. Because the payments themselves are tax credits, they are not taxable income.
Unemployment Insurance Benefits
Lawmakers responded to the unprecedented increase in unemployment in 2020 with large increases in the payment of unemployment insurance (UI) benefits. The increases include Federal Pandemic Unemployment Compensation (FPUC) that provided $600 per week of additional compensation from March 28th to July 30th (with a $300 per week benefit provided through executive action until the renewal of FPUC benefits in late December); a longer duration of benefits, for an additional 13 weeks after state benefits expire through Pandemic Emergency Unemployment Compensation (PEUC); and an expansion in the number of eligible recipients through Pandemic Unemployment Assistance (PUA), which allows contract and gig economy workers to receive UI benefits.
The UI benefits helped support American incomes through the year and are considered taxable income. According to the U.S. Department of Labor, about $6.4 billion in unemployment insurance benefits were paid in the fourth quarter of 2019. By the second quarter of 2020, this jumped to $64.2 billion, and the third quarter of 2020 saw $48.7 billion in UI benefits paid. The higher UI benefit payments follow the rise in unemployment from 3.5 percent in February 2020 to a peak of 14.8 percent in April 2020. The unemployment rate remains elevated at about 6.7 percent in December.
To avoid an unexpected tax bill when filing their taxes, taxpayers would have needed to correctly withhold taxes from their UI benefits. For federal income taxes, a taxpayer can opt into a 10 percent withholding rate, but it is not required. Taxpayers may additionally remit quarterly estimated taxes throughout the year. Many taxpayers likely have not properly withheld or saved tax owed on UI benefits, which may create an unexpected tax liability when they file for the 2020 tax year.
Refundable Tax Credits
As part of the latest coronavirus relief package, policymakers made an adjustment to the way the Earned Income Tax Credit (EITC) and the Child Tax Credit (CTC) are calculated for the 2020 tax year. Normally, both credit amounts are calculated based on earned income and phase in over time for lower-income earners. The phase-in with earned income means that an economic downturn can lower the value of credits for people who may have lost their incomes due to the pandemic.
The latest coronavirus relief package addresses the issue by allowing filers to use 2019 earnings in lieu of 2020 to determine credit eligibility for tax filing. The “lookback” provision will raise the total amount of refundable credits provided to lower-income earners. It will be important for filers to compare earned income for both tax years to see what is best for their tax situation. The Joint Committee on Taxation (JCT) estimates that the lookback will reduce federal revenue by about $4.1 billion in 2021.
Many filers are concerned about tax refunds heading into tax season. The combination of unique economic and tax policy circumstances may affect refunds both for individual taxpayers and in the aggregate.
Economic recessions tend to impact refunds because taxpayers have lower incomes and tax policy tends to provide stimulus that flows into refund amounts. During the Great Recession, for example, total refunds rose above trend from about $250 billion in 2007 to $335 billion in 2009 before remaining flat for the next several years (see the following Figure). The share of returns with a tax refund, however, remained stable at between 75 percent and 80 percent of returns filed in those years. The average tax refund also rose, from about $2,200 in 2007 to about $2,600 in 2009, before falling to about $2,200 in 2016.
Where tax refunds will end up for the 2020 tax year is uncertain, though the trends tend to point toward higher refund levels compared to recent tax seasons. Many taxpayers have yet to claim their economic impact payment. Up to nine million individuals eligible for a payment had not received one as of mid-September 2020. Additionally, individuals who have not received a second-round stimulus payment by today must indicate it on their tax return to receive this credit. Filers will have to watch that they do not double claim these payments if the second-round payment arrives after filing a return, which may require an amendment to the tax return.
The payments will tend to increase refunds, all else equal, though it’s unclear how many people who typically do not file a tax return will do so this year to claim a payment.
The lookback adjustment for tax credits may also help sustain refund levels for lower-income taxpayers. The estimated $4 billion cost of the adjustment is about 1 percent of 2019 tax refunds processed, though the revenue loss is unlikely to translate to a direct dollar-for-dollar increase in tax refunds.
The increase in unemployment insurance claims could be a downward force on tax refunds, as some filers may have additional tax owed if they have not properly withheld tax over the tax year. The same problem, however, was not so large during the Great Recession to offset the other trends pushing tax refunds up overall. It remains to be seen, though, if tax owed on higher benefit amounts over the current recession (including the $600 per week payments under FPUC) reduces refunds meaningfully.
While tax refunds are an area of focus for taxpayers, it’s important to remember that tax refunds are not an accurate way of looking at tax liability or evaluating how tax changes impact taxpayers’ after-tax incomes.
The 2021 tax season will be a messy one for taxpayers, the IRS, and state tax authorities because of the tax changes made over the past year and the logistical challenges due to the ongoing pandemic. The IRS should provide flexibility for individuals and businesses seeking to comply with and understand their tax obligations for the year while looking forward to ways that would simplify tax compliance and the filing process.