Up to $20,400 of 2020 Unemployment Benefits May Be Nontaxable Due to Recent Changes to Coronavirus Relief Legislation:

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If you haven’t filed your taxes for 2020 yet and received unemployment compensation in 2020, you may want to hold off for a bit longer. Changes made to the American Rescue Plan of 2021 in the US Senate included a provision that creates a special exemption, potentially allowing the exclusion of up to $20,400 in unemployment benefits from taxable income. Today, the legislation was passed in the House of Representatives and is expected to be signed by the President imminently. With over 50 million Americans having filed for unemployment benefits in 2020, this change has the potential to impact a large portion of the federal income tax returns filed this year, many of which have likely already been filed.

The Revenue Act of 1978 added section §85 to the Internal Revenue Code, making unemployment benefits includable in taxable income for the first time in 1979. The Senate, in adding §9042 to the American Rescue Plan of 2021, is proposing to modify §85 of the Internal Revenue Code to provide a special rule for 2020 as follows: “In the case of any taxable year beginning in 2020, if the adjusted gross income of the taxpayer for such taxable year is less than $150,000, the gross income of such taxpayer shall not include so much of the unemployment compensation received by such taxpayer (or, in the case of a joint return, received by each spouse) as does not exceed $10,200.”

Parsing the language of §9042, a couple of items are worth pointing out. First, the section explicitly states that each taxpayer is eligible to exclude $10,200 of unemployment compensation from their gross income. That means in the case of joint filers, the provision could reduce a household’s taxable income for 2020 by $20,400 — a considerable tax benefit. However, the bill provides a hard cutoff for claiming the benefit at $150,000 of adjusted gross income, and the threshold is the same for individual and married taxpayers.

It’s somewhat unusual that different income limitations wouldn’t be set for individual and married taxpayers, as it means that individual filers are not only going to be more likely to qualify to exclude unemployment benefits than joint filers, but are also likely to reap larger benefits from the provisions. Take, for example, a single filer with an AGI of $149,000. Based on 2020 tax rates, that taxpayer’s highest marginal tax rate would be 24%, while a married couple filing jointly with the same AGI would have a highest marginal rate of 22%, meaning the exclusion of $10,200 in unemployment benefits would net the individual filer approximately $2,448 in tax savings, while a similarly situated married couple would net about $2,244 in tax savings. However, because the $10,200 cap applies at an individual level, married couples in the highest marginal rate could potentially net a tax savings of $4,488 if both spouses received unemployment compensation.

Because the $150,000 cap is a hard threshold (meaning taxpayers with $149,999 in AGI will receive the full benefit of the provisions while those with an AGI of $150,000 will receive no benefit), there may be an incentive for married taxpayers to file separately for 2020 in order to take advantage of the bill’s provisions. While it’s an old adage that filing jointly is likely to provide tax savings over filing separately, that may not be the case for a number of taxpayers this year.

For the sake of a simplified example, let’s say a married couple each earn $64,800 in wages and each received $10,200 in unemployment compensation in 2020. If they file jointly claiming the standard deduction, they should expect to owe about $19,124 in federal income tax and would receive no benefit from the §9042 exclusion rules because their combined AGI would be $150,000. If they were to file separately, they would each owe about $9,568, for a combined total of $19,136 in federal income tax. Under normal circumstances, filing jointly would therefore net them a tax savings of $12. However, because of §9042, filing separately would allow each spouse to exclude that $10,200 of unemployment income on each of their separately filed returns, bringing the tax owed on each return down to $7,324, for a combined total of $14,648, a $4,476 reduction over their jointly filed return. Now, there are certain credits and deductions that aren’t available to married couples filing separately, so the analysis won’t always be so straightforward, but if you’re married and have a combined AGI over $150,000, it may be worth speaking with your tax preparer about filing separately if one or both spouses received unemployment income in 2020.

Furthermore, because this is a retroactive change applicable to a now closed tax year, planning options for taking advantage of the provision are somewhat limited. However, there are a few things that can be done before April 15th, 2021 to lower your AGI for the prior year. The first is to make a contribution to a traditional IRA. Unfortunately, this isn’t likely to be a viable option for single or MFS filers, as the threshold for deducting IRA contributions phases out well below $150,000 for those filers. However, spouses that file jointly, where either one or both of the spouses are not covered by a retirement plan at work, can make a contribution to an IRA prior to April 15th to reduce their AGI up to a potential maximum of $14,000 through IRA contributions in order to qualify for the unemployment income exclusion. Likewise, both single and joint filers with high-deductible health plans can make contributions to Health Savings Accounts prior to April 15th to lower their 2020 AGI below $150,000 and qualify for the exclusion.

If you prepare your own taxes using tax preparation software and you received unemployment compensation in 2020, you’d be well advised to wait until the bill has been signed and the software companies are able to update their software to accommodate the changes before filing your return. It remains to be seen exactly how long that will take, though as we’re already nearing the middle of March, I’m sure it will be a scramble by the companies that produce such software to implement the necessary updates. If you use a professional return preparer, be sure to ask them to review your eligibility to exclude unemployment compensation, especially if you’re a married couple with income around the cutoff threshold. There are strategies to qualify where you otherwise would not have, and, given the magnitude of the potential tax benefit in play, it’s worth exploring your options. If you’ve already filed your return for 2020, don’t fret; once the legislation is signed and in effect, you should be able to amend your return to exclude the unemployment benefits from taxable income if you qualify. Even if you’ve already filed jointly, you can amend your return to elect married filing separately, so long as you do so before the April 15th deadline.