Three Big Income Tax Surprises In Tax Year 2020

Most every income tax filing season has some surprises - but not many more than for those who worked remotely @ home in a different state than where their employer is located or for those who received unemployment insurance benefits caused by the government shutting down businesses under the pretense of concern for the Wuhan coronavirus.  There were also a few surprises for people scheduled to take RMDs from IRAs.

The IRS's decision to extend the filing deadline to May 17 gives affected people a few more weeks to cope with these surprises.

For states with an income tax people are usually taxed by the state where their employer's office or business is located & of course this is where they normally went to work every day before March 2020.  After working remotely from home for about ten months in 2020 a significant number of people are finding that more than one state is making income tax claims on their earnings.

Some remote workers have found they are taxed in the state where their employer is located unless the employer actually requires them to work remotely in another state.  If two or more states are involved the state income tax liability is never based on where it is convenient for the work to be performed.  Such affected workers may have to file two, or more, state income tax returns.

States like New York are very aggressive in claiming NY state income taxes are due for people working from home in another state but whose employer is located in New York.

The biggest surprises could come to people who found that working remotely was so convenient that they traveled to the homes of friends, family, or second homes in states other than where their principal residence (main home) is located to work.  Some states, such as Michigan, require someone who is not a resident to pay Michigan state income tax on the money they earned the first day the person starts working remotely in Michigan.  Some states subject all of your income to state income taxes regardless of where it was earned, leaving you to hope there is a reciprocal agreement between states (like PA & NJ) or that your state of principal residence is reasonable in recognizing taxes paid to other jurisdictions (i.e., income earned outside your principal residence state is subtracted so that such income is only taxed once @ each state level). 

This state income tax problem started when California recognized that professional athletes were easy high income targets who were good sources of extra income for the state.  A professional NBA basketball player living in Florida, a state with no state income tax, still pays state income tax in 18 other states that he plays basketball in.

There are 41 states that have state income taxes & more than 20 of them have a one day rule for owing state income taxes if someone travels there to work or works there remotely.  Technically, someone going to a trade show or one day seminar could be liable for state income tax in such a state.

There are 16 states that have agreements that make it easier for those who commute across state lines to come under the jurisdiction of the state in which they live.  

Six states tax someone working remotely based on where the employer's office is located if the remote work is not required by the employer @ a genuine work location.

Nine states have no state income tax - Alaska, Florida, New Hampshire, Nevada, South Dakota, Tennessee, Texas, Washington, & Wyoming.

In balancing out any dual state income tax payments you should take into account the tax rates of both states.  For instance you could get a credit for taxes paid to a state other than your principal residence state.  If your principal residence state has a lower tax rate than the state you chose to work in you could get a tax surprise if you had figured it was convenient to work in the other state for part of the pandemic scarred year.

Remote workers should be better prepared after this income tax filing season.  Being proactive in understanding your state income tax withholding & the rates of other states you choose to spend time in is a great start.

The second big surprise in tax year 2020 affected people who had never received unemployment benefits in their lives - only to find out that unemployment compensation is taxable for federal purposes including money received under the Federal Pandemic Unemployment Compensation (FPUC) program.  In brief, millions of workers had thousands of dollars per family in income tax liabilities on their unemployment benefits.

New Jersey allowed people to voluntarily have 10% of their unemployment benefit withheld & sent to the IRS so @ least there was a warning of what was to come for people in NJ.  But California did not withhold taxes on the enhanced federal $600 supplemental benefits made through the FPUC so many Californians were unsuspecting of the income tax liability on their unemployment benefits.

The IRS started accepting income tax returns on February 12 with most early filers expecting a refund, as usual, figuring it made no sense letting the government hold their money interest free any longer than the beginning of the year.  Do you see something wrong with this reasoning?  

The income taxes due on the unemployment benefits cut into that refund so on March 11, 2021 the American Rescue Plan was enacted that retroactively  included a new exclusion of up to $10,200 of unemployment compensation, per recipient, in households whose adjusted gross income was less than $150,000 in tax year 2020.  It wasn't until March 23 that the IRS released guidance for those affected who had already filed 2020 returns & for those who haven't - a combination that includes 40 million affected Americans.  By the beginning of March the IRS already had received 45 million income tax returns, many of which would be affected by the new law exempting some unemployment benefits from taxation.

The government is so anxious to send people money that the IRS has told affected tax filers, who had already filed, not to prepare amended returns but rather the IRS would calculate the amount due & send out the checks.  In any event everyone will be made whole one way or the other in this regard.  

A $10,200 unemployment tax exemption in 2020 amounts to every recipient of the $600 per week unemployment compensation, in a household that totals a cumulative income of $150,000 per year, or less, receiving the top $600 per week benefit for 17 weeks tax free.  Since many people received more income from unemployment compensation (both regular state unemployment compensation like $1,234 per week in Massachusetts plus the $600 per week federal supplement) than they did working & paying both income & payroll taxes on their incomes it is not surprising that many firms & small businesses have had trouble hiring people.  The tax exemption described above only exacerbates the problem. 

The third big surprise came on March 27, 2020 when Congress passed & Trump signed the Coronavirus Aid, Relief, & Economic Security Act (CARES Act) that temporarily waived required minimum distributions (RMDs) in 2020 for anyone with an RMD due in 2020 (the Secure Act of 2019 had already changed the starting age for RMDs to 72) including IRA beneficiaries taking single life expectancy payout distributions, & IRA holders who had turned 70 & a half in 2019 & had until April 1, 2020 to take their RMD for tax year 2019.  Talk about good timing.

Congress included this RMD waiver in the CARES Act because 2020 RMDs are based on the fair market value of an IRA on December 31, 2019 when the DJIA was 28,462 (S&P 3,221).  The Dow had dropped to 22,552 (S&P 2,630) on the date the CARES Act was signed into law meaning that without enactment of the CARES Act many IRA holders would have been taking large taxable RMDs on a market value that no longer existed.

The complication involved taxpayers who had already taken their 2020 RMD before enactment of the CARES Act or who had submitted their income tax returns figuring in a 2020 RMD (realized or merely projected) & its tax liability for tax year 2020 & included this in making the first estimated tax payment for tax year 2020 - such people would have overpaid, & some substantially overpaid. 

The IRS ultimately altered their rules allowing early 2020 RMDs to be repaid, treating the repayment as a tax-free rollover not subject to the one rollover every 12 months rule.  The estimated tax payer who overpaid was on his own to recalculate the other three estimated tax payments making sure he did not underpay for the year or any other quarter, which would have drawn an underpayment of estimated tax penalty plus interest, even though he overpaid the first estimated tax payment.

These are the three big income tax surprises for tax year 2020 that I have come across..  Please let me know of any others that you are aware of.

All of the income tax surprises described above stem from the adoption in Amendment XVI of the Constitution of the income tax "from whatever source derived."  In this case the sources are assessments of state income taxes depending on where you live or work or where your employer is located, the federal government taxing unemployment insurance benefits, & the federal government deciding what portion, & when, your retirement savings will be taxed.

There is a better way & it is the FairTax.