Hard hit financially by the coronavirus recession? Watch out for these 2 tax traps
Taxes are a certainty – we learned this from Founding Father Ben Franklin’s famous quote, “Nothing is certain except death and taxes.” But the amount of income tax you pay each year is a moving target based on your income. If you are one of the millions of people hard hit financially by the coronavirus recession, your efforts to stay afloat may leave you with surprise tax debt.
In March 2020, the federal government passed the CARES Act, a $ 2 trillion relief program to help households and small businesses manage economic shutdowns caused by the coronavirus pandemic. The CARES Act allowed stimulus checks, small business loans to cover payrolls, and even financial assistance to state and local governments. But there are two provisions of the CARES Act that could bring surprises at tax time: increasing unemployment assistance and reducing restrictions on 401k withdrawals.
1. Unemployment income and no withholding tax
You may be surprised to learn that unemployment income is taxable. You can choose to have income taxes withheld from your unemployment check, but you may not want to. Since withholding would reduce your income when you need it most, you may be inclined to skip it and bear the consequences later.
Normally, that’s a reasonable bet, especially when you expect your job to be replaced quickly. A typical unemployment check is less than half of your working salary, so the tax burden slowly increases.
These are not normal times, however. The first problem is that in this economy it may take longer than you would like to replace the job you lost. In addition, unemployment benefits until the end of July included a Weekly supplement of $ 600, an advantage allowed by the CARES law. This four-month supplement of $ 600 alone adds more than $ 9,500 to your taxable income. A longer duration of unemployment, combined with this higher unemployment benefit, can create a significant and surprising tax liability if you have not opted for withholding at source.
The CARES Act has also made it easier and cheaper to withdraw money from your 401k. Normally you would pay a penalty of 10% plus income tax on 401k early withdrawals. In 2020, if you have been affected by COVID-19, the 10% penalty is waived. You still owe income taxes on the withdrawal, but you can pay them over the next three years. Alternatively, you can pay off your withdrawal within three years and ignore the tax bill altogether.
That doesn’t mean you have three years to sit on that tax liability, though. This means that you will owe a third of the taxes on that withdrawal in each of the following three years. Suppose you take the maximum withdrawal of $ 100,000 and your effective federal tax rate is 20%. Your total tax payable is $ 20,000. Without a refund, you’ll owe $ 6,667 in taxes, just on that $ 401,000 withdrawal, in 2020, 2021, and 2022. If you end up paying off the distribution within three years, you’ll get a credit for the taxes you pay. have paid.
There is also another complication to consider. You also owe state tax on your 401k withdrawal. Your state can follow federal guidelines in giving you three years to pay these taxes, or not. Check with your 401k plan administrator or local tax professional to find out.
Estimate of your taxes 2020
You cannot escape income tax if you are unemployed or 401k withdrawals, but you still have time to avoid tax penalties. Tax penalties arise when you don’t pay at least 90% of your 2020 tax bill or 100% of your 2019 actual taxes in the 2020 tax year. If you now estimate your taxes for 2020, you have several more months to cover any shortfall and avoid these penalties.
The most accurate tax estimate will come from an experienced tax expert. But if you are strapped for cash, you will prefer a free online calculator. Fortunately, the IRS has one that will do the job.
the Withholding tax estimator is designed to help you complete Form W-4, but you can also use it to estimate your tax payable at the end of the year. The estimator will ask for your regular salary income and deduction to date, your unemployment income, and any income from 401k withdrawals. Note that the program does not automatically take into account the special CARES tax rules that apply to 401k 2020 withdrawals. To adjust this, use one-third of your actual withdrawal amount. If you withdrew $ 100,000 from your 401k, for example, you would enter $ 33,333.33 in the estimator.
If the estimator foresees an underpayment for 2020, you will have to finance the shortfall this year via quarterly tax payments. These payments can be sent by post with Form 1040-ES or paid online. Alternatively, if you are already back to work, you can increase the amounts withheld from your paycheck and make up the difference that way.