Recovery rebates: Tax planning pitfalls and opportunities

The Coronavirus Aid, Relief, and Economic Security (CARES) Act¹ provides for a recovery rebate credit of $1,200 for individuals or $2,400 for couples and $500 per child against the tax imposed in the first tax year beginning in 2020.² The credit is phased out at a rate of 5% of a taxpayer’s adjusted gross income (AGI) exceeding $150,000 for joint filers, $112,500 for a head of household, and $75,000 for everyone else.³

The Coronavirus Aid, Relief, and Economic Security (CARES) Act⁴ provides for a recovery rebate credit of $1,200 for individuals or $2,400 for couples and $500 per child against the tax imposed in the first tax year beginning in 2020.⁵ The credit is phased out at a rate of 5% of a taxpayer’s adjusted gross income (AGI) exceeding $150,000 for joint filers, $112,500 for a head of household, and $75,000 for everyone else.⁶

To help with the current COVID-19 crisis and expedite the delivery of rebate credits to people, an advanced refund amount is calculated based on taxpayers’ AGI for 2019 or for 2018 if 2019 amounts are not yet available.⁷ This prepaid amount is an estimate of the credit that the taxpayer should receive based on the 2020 tax year and does not necessarily reflect the actual amount of the credit.

Potential Issues

Since a taxpayer’s advanced refund is just an approximation of the credit to be received as part of the 2020 tax return, changes in the taxpayer’s AGI in 2020 can make a significant difference in determining whether a taxpayer will ultimately qualify for the recovery rebate credit. Given the economic uncertainty of 2020, many taxpayers will have significant changes in income. Some taxpayers such as nurses or paramedics may work more and be in greater demand, resulting in higher income in 2020 than in previous years, while other taxpayers may lose jobs, be temporarily laid off, or have substantial decreases to their income.

For example, if a married couple with two children receive the full advanced refund of $3,400 based on 2019’s AGI, but their income increases to over $150,000 this year, they may be concerned that they will receive a surprise bill when filing their taxes next year, as the credit they already received begins to phase out. While the wording in the CARES Act is somewhat ambiguous, a Congressional Research Service report clarifies that the CARES Act does not require taxpayers to repay any advanced refund payments if their 2020 AGI exceeds the income limits for the refund credit as calculated on a 2020 return.⁸ Therefore, this couple would be allowed to keep the entire $3,400 refund without increasing their tax liability when filing their 2020 return. This also means people may benefit from delaying their 2019 filing until after receiving the refund payment if their 2018 income was lower.

On the other hand, if the advanced credit is less than the actual credit, then taxpayers will be able to claim the difference (as an increased refund) on their 2020 income tax returns. For example, another married couple with two children may not receive an advanced refund at all if they had high income in 2018 or 2019. However, due to the current crisis, their income may be substantially lower in 2020, which would allow them to qualify for part or all of the credit on their 2020 return. Furthermore, if children are born or adopted in 2020 (and possibly 2019 if the recovery rebate is based on 2018), taxpayers will be eligible for an additional $500 for each new child, further increasing their credit. In that case, they may want to consider the increased credit when setting their withholding or making estimated payments. This is especially true if one spouse continues to work while the other has lost his or her job due to the crisis.

Since the tax credit is only valid for 2020, taxpayers have more of an incentive to push income to subsequent years, increase their 2020 deductions before AGI, or take advantage of other tax planning strategies to keep the recovery credit from being phased out in 2020. This could mean using the advanced refund to increase pretax retirement contributions, giving more to charity to take advantage of the AGI charitable contribution provision, or even choosing to file married filing separately to preserve the recovery rebate credit for at least one spouse.

Using the advanced refund to increase retirement contributions and maximize the recovery refund

Since taxpayers have an incentive to push income to subsequent years or increase their 2020 deductions, one of the biggest opportunities to lower AGI is with 401(k) contributions. Most taxpayers are not able to max out their 401(k) contributions. However, taxpayers who are in jeopardy of losing part of their credit due to the phaseout might want to use any advanced refund that they receive to increase their 401(k) contributions. Since 401(k) contributions are pretax contributions, taxpayers should be able to increase their 401(k) contribution more than the advanced refund amount without revising their personal budgets.

For example, for the family of four mentioned above, assume the family is in a 22% marginal federal tax bracket and an 8% marginal state income tax bracket for a combined marginal tax rate of 30%. This family could use the advanced refund of $3,400 to increase their 401(k) contribution to $3,400 ÷ (1 – 0.30) = $4,850 (all numbers are rounded) without affecting their after-tax take-home pay. (See the table “Increased 401(k) Contribution When Family AGI Is Less Than $150,000,” below, which in this example also assumes the employer match would add $290 to the 401(k) contribution.) However, assume the couple’s income is currently above the $150,000 phaseout of the advanced refund and the couple received only a $2,000 advanced refund. If they expect approximately the same amount of income in 2020, then the 5% phaseout rate acts as an additional marginal tax. In that situation, the combined marginal tax rate for the family is 35% (30% + 5% phaseout rate). In that case, the couple could increase their 401(k) contribution by $2,000 ÷ (1 – 0.35) = $3,075 without decreasing the net after-tax income available to the family.

As an additional example, assume the couple currently have AGI of $160,000, their advanced refund would be reduced by $500 ([$160,000 – $150,000] × 5% = $500) (see the table “Increased 401(k) Contribution When Family AGI Is Over $150,000”, below). The 5% phaseout of the advanced refund acts as an additional marginal tax in this instance so the marginal tax rate becomes 35% (30% combined federal and state marginal rates plus the 5% phaseout). If this couple were able to increase their 401(k) contributions by $10,000 (gross), they could maximize the recovery rebate credit. The couple would save $3,000 in federal and state taxes and would increase their advanced refund by $500 for a total of $3,500 in savings/refund leaving an after-tax cost of the increased contribution of $6,500. Since the family of four would have already received $3,000 as part of the advanced refund, the couple would need to reduce their take-home pay by only $4,500 during the year. Assume the employer matches some percentage of 401(k) contributions⁹ and that, in this case, the employee would receive an additional $600 matching contribution. In total, the employee would be increasing his or her 401(k) contributions by $10,600.

Forgoing retirement distributions

For retired individuals, the CARES Act eliminated the required minimum distribution requirements in 2020. Taxpayers who have the resources to forgo IRA and 401(k) distributions this year could lower their AGI to increase or preserve the current-year recovery rebate if they did not receive the entire advanced refund due to the phaseout. This strategy would be especially beneficial to those individuals who are heavily invested in securities that have declined in value due to the crisis.

On the other hand, some retirees who lost part-time jobs may find themselves in a lower tax bracket and not in jeopardy of losing any of the recovery rebate. For those retirees, it may be beneficial to take a distribution while they are in a lower tax bracket if they anticipate their income and marginal tax rate to increase again in the future.

Becoming more charitable

The CARES Act also provides an increased charitable deduction that allows taxpayers to claim up to $300 as an above-the-line deduction,¹⁰ enabling charitable deductions to be subtracted from gross income and further lowering AGI. While the amount of the above-the-line deduction is not high, it does help increase the recovery rebate. Any charitable contribution amounts above $300 will not increase the recovery rebate, but it is also important to note that the AGI limitation on charitable contributions for 2020 is also revised to 100% of AGI for individual taxpayers. This may be useful for taxpayers who have substantial wealth but not as much income in 2020.

Married filing separately may be an option

In most situations, it is better for a married couple to file a joint return rather than file separately. However, the phaseout of the recovery rebates credit may make filing separately beneficial. Taxpayers who qualify to file married filing jointly may instead file separately without affecting the credit. For married taxpayers whose AGI causes them to lose over half the credit and where one spouse makes disproportionately more than the other, it may be better to file separately, allowing the spouse with lower income to receive part or even all of the credit that the couple would not have been eligible for had they filed married filing jointly.

College-age children  

Qualified children over the age of 17 and qualified relatives that are claimed on another taxpayer’s tax return as a dependent are not eligible for the recovery rebates and will not receive advanced refunds. Because they are not qualifying children under age 17, a taxpayer claiming them as a dependent is also not entitled to an additional $500 recovery rebate credit for these individuals. However, a taxpayer claiming a member of either of these groups as a dependent is entitled to the $500 dependent credit.

If children over 17 cannot be claimed as dependents in 2020, they are eligible for the $1,200 credit. While they will not receive the advanced refund if they were dependents in 2019 (or 2018, if a 2019 return has not been filed at the time the advanced refund is issued), they are eligible for the recovery credit. It is important to note that this is a refundable credit and does not have a minimum income requirement. Therefore, in most instances, it will overall be more beneficial for a family if children over age 17 cannot be claimed as a dependent in 2020.

However, there are situations where the overall benefit to a family of a child’s qualifying as a dependent is more than the $500 dependent care credit. For example, for college-age children, parents may be claiming the American opportunity tax credit (AOTC) or lifetime learning credit (maximum $2,500 for the AOTC or $2,000 for the lifetime learning credit). A child who is a student that cannot be claimed as a dependent by his or her parents may not be able to fully benefit (or benefit at all) from these credits on his or her own return. Assuming that the parents are not subject to the phaseouts for the education credits, if the parents can claim the child as a dependent, the parents’ receiving a dependent care credit and the AOTC or lifetime learning credit potentially¹¹ exceeds the benefit of the student receiving the recovery rebate credit. Therefore, it would be more beneficial in these cases for the student to qualify as a dependent of theparents.

Another instance where it may be better for qualified children over 17 and other qualified relatives to continue to qualify as dependents is when they qualify the taxpayer for head-of-household status. Head-of-household status provides significant tax benefits, increasing the standard deduction, allowing the use of beneficial tax tables, and qualifying for other tax benefits that would typically outweigh the benefits of the recovery rebate credit.

Other planning methods

Given that this credit is only available for 2020, there is a greater incentive to push more income to the future than would exist for reoccurring credits that may be affected in future years when income is shifted to future periods. Income rates for taxpayers near the threshold are typically between 22% and 24%, and the 24% rate goes up to $163,300 for single taxpayers and $326,600 for taxpayers who are married filing jointly, so in most situations, taxpayers shifting income to future years will not be in substantially higher tax brackets.

Taxpayers in the credit phaseout range may want to look at other opportunities to lower their income. Cash-basis taxpayers may want to accelerate deductible payments or delay the collection of income. Taxpayers with rental property may consider doing some delayed maintenance projects before the end of the year. Independent contractors and small business owners may want to make year-end purchases that can be deducted under Sec. 179. Investors may want to take some losses on investments up to their net annual capital loss allowance of $3,000.

Pitfalls related to tapping into IRAs for funds and converting traditional IRAs to Roths

Taxpayers might choose to use their IRAs to get money during this crisis. The good news is that, if the taxpayer is affected by COVID-19, he or she can take a coronavirus distribution up to $100,000 from his or her IRA and have three years to repay the amount, without recognizing it as income.¹² However, a taxpayer who does not pay the coronavirus distribution back is required to recognize the amount in income ratably over the three-year period, although he or she will not be subject to the 10% early-withdrawal additional tax.¹³ The amount included in income in 2020 may reduce the amount of the recovery rebate the taxpayer receives if he or she did not receive the entire advanced refund, so that should be considered before taking a coronavirus distribution from an IRA as other than a loan.

Also, while the valuations of investments are low, taxpayers might take the opportunity to convert a traditional IRA to a Roth IRA. This may be particularly true for taxpayers affected by COVID-19 who are eligible to take a coronavirus distribution, as they would be able to withdraw part of the IRA balance to pay for the taxes for the conversion without being subject to the 10% early-withdrawal additional tax. However, converting the IRA to a Roth IRA will increase taxable income, which may cause part or all of the recovery rebate credits to be phased out. Taxpayers should be encouraged to consider these additional costs before making such a conversion.

Another pitfall is that the special rules allowing coronavirus distributions from IRAs only apply to those who are affected by COVID-19. The CARES Act defines people affected by COVID-19 to include taxpayers who are positively diagnosed with COVID-19 by a test approved by the Centers for Disease Control and Prevention or who have spouses or dependents diagnosed with COVID-19 by such a test; and taxpayers who experience adverse financial consequences as a result of being quarantined, losing a job, or having reduced hours due to the virus; being unable to work due to lack of child care due to the virus; closing or reducing the hours of personal businesses due to the virus; or other factors determined by the secretary of the Treasury.¹⁴ If taxpayers do not meet one of these criteria, they will not be eligible for the special rules regarding early withdrawals.

Plan now to increase the payment

Advanced refunds of the recovery rebates put money into taxpayers’ hands to meet economic needs during the current crisis. However, those rebates are only estimates of the recovery rebate credit on the 2020 tax return. Taxpayers need to be aware of the potential opportunities to increase and/or preserve those amounts through proactive tax planning.

Footnotes

¹Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136.

²Sec. 6428(a).

³Sec. 6428(c).

⁴Sec. 6428(f).

⁵Crandall-Hollick, “COVID-19 and Direct Payments to Individuals: Summary of the 2020 Recovery Rebates/Economic Impact Payments in the CARES Act (P.L. 116-136),” p. 4 (Congressional Research Service, April 17, 2020), available at crsreports.congress.gov.

⁶According to Fidelity, the average employer 401(k) match for the first quarter of 2019 was 4.7% of salary (Fidelity Q1 2019 Retirement Analysis, p. 2 (May 9, 2019)).

⁷Sec. 62(a)(22).

⁸ Secs. 25A(b)(1) and (c)(1).

⁹CARES Act §2202.

¹⁰ CARES Act §2202(a)(5).

¹¹CARES Act §2202(a)(4)(A).