Budget

How to prepare for 2021 tax season now

If your tax planning begins a couple of weeks before April 15, you might be in for a stressful time. However, suppose you’re trying to minimize your tax liability and being proactive about your tax situation rather than playing the refund guessing game next April. In that case, you need to prepare for the 2021 tax season now.

To get started for next year’s tax season, this means you’ll need to:

  • Check your tax withholdings and adjust your Form W-4, if necessary.
  • Make a list of all the companies — such as your employer, your bank, and your stock brokerage — from whom you’re expecting to receive a tax form next year.
  • Consider increasing your contributions to your workplace 401(k) or other tax-advantaged retirement plans before the end of the year.

Then you’ll need to think ahead to what tax deductions and credits you may be eligible for on your 2021 tax return and take steps now to maximize those available benefits.

 

Forms you might need…

     Employees

  • Wage and Tax Statement (W2)

     Self-employed and freelancers

  • Income for Non-Employee Compensation (1099-NEC)
  • Payment Card and Third Party Network Transactions (1099-K)

     Unemployed

  • Certain Government Payments (1099-G)

     College students and graduates

  • Tuition Statement (1098-T)
  • Student Loan Interest Statement (1098-E)

     Investors

  • Dividend Income (1099-DIV)
  • Sale of Property (1099-S)
  • Partnership of S-Corporation Income (Schedule K-1)
  • Rental Income (1099-MISC)

     Homeowners

  • Mortgage Interest Statement
  • Real Estate Taxes

     Charitable donors

  • Charitable Donation Statements

     Retirees

  • Social Security Benefits Statement (SSA-1099)
  • Distributions From Pensions, Annuities, Retirement, etc. (1099-R)

 

Tax Deductions vs. Tax Credits

Before getting into specific tax benefits you may be eligible for so you can plan for them, you must understand what tax deductions and tax credits are and what they’re worth to you.

Tax Deductions

In a nutshell, a tax deduction is a tax benefit that reduces the amount of your income that’s subject to income tax. So let’s say you’re single and your taxable income is $9,000 without a particular deduction. Because you’re in the 10% tax bracket, your tax liability for the year would be $900.

But wait! Don’t forget the Form 1098-E from your student loan servicer! So you dig it up, and it says you paid $1,000 in student loan interest. This makes you eligible for the student loan interest deduction, and your taxable income is now lowered to $8,000 (your original $9,000 taxable income less the $1,000 student loan interest deduction).

So what’s your tax liability now? It’s $8,000 x 10%, or $800. And how much actual tax benefit — dollars back in your Pocket — did the student loan interest deduction provide for you? $100, which is the difference between your old tax liability and your new tax liability.

In general, the actual tax benefit afforded to you by a particular deduction is the amount of the deduction multiplied by your marginal tax rate, which is generally the tax bracket you are in (unless the deduction lowers your tax bracket, in which case the math is a little bit more involved). So, if you are in the 10% tax bracket and you are eligible for a $1,000 deduction, that deduction will generally be worth $100 in actual cashback in your Pocket.

 

Tax Credits

On the other hand, a tax credit is a tax benefit that gives you a dollar-for-dollar reduction in your tax liability equal to the credit amount.

This is a little bit easier to understand, and there’s less math involved. So let’s say, again, that you have a $9,000 tax liability for the year without a particular tax credit. Then, a $1,000 tax credit will directly decrease your tax liability by $1,000 to $8,000. In general, if we could magically give you your choice between a $1,000 tax deduction and a $1,000 tax credit, you’d probably want to go with the credit.

 

Unemployment Planning

If you received unemployment benefits in 2020, you were probably glad to hear that the American Rescue Plan Act excluded the first $10,200 of unemployment benefits from federal income tax for the 2020 tax year.

While this benefit hasn’t been extended to 2021, one thing you really want to keep track of is how much money you collected from unemployment in 2021. “Why do I have to keep track of this? Won’t my state send me a Form 1099-G for 2021 telling me how much they paid me in unemployment during the year?” The answer to that question is, of course, “Yes, your state will send you a Form 1099-G indicating how much it thinks it paid you in 2021 unemployment benefits.” But here’s the thing, due to the beefed-up unemployment benefits implemented in the wake of the COVID-19 pandemic — such as the extra $300 – $400 payments per week — fraudulent unemployment claims went through the roof in 2020 and continue into 2021.

This means that it’s possible that some fraudster may have used your social security number to file a fraudulent unemployment claim in your name! So it’s very important for you to keep your own records of how much unemployment you collected in 2021 and then compare that amount to the 2021 Form 1099-G that your state sends you. If the amounts are different, alert your state unemployment office immediately and request a corrected Form 1099-G. Start adding up your unemployment figures now and keep track of these amounts, so you have them ready next tax season.

 

Recovery Rebate Credit

If you didn’t get the third stimulus payment or received less than the full amount of $1,400 each for you, your spouse, and any dependents you claim, you may be eligible to take the Recovery Rebate Credit on your 2021 tax return for the difference.

However, keep in mind that the 2021 Recovery Rebate Credit is based on your 2021 income, phasing out at the same income levels as the third stimulus check.

 

Filing StatusPhaseout Begins (AGI)Phaseout Ends (AGI)
Single$75,000$80,000
Head of Household$112,500$120,000
Married Filing Jointly$150,000$160,000

 

For example, if you’re single with no dependents and made $80,000 at your job in 2019 and 2020. Unfortunately, based on your income, you were not eligible to receive a third stimulus check. But even if you make the same $80,000 from your job in 2021, you still may be able to get that Recovery Rebate Credit. How? Well, if you can somehow manage to get your 2021 adjusted gross income below $75,000, you would be eligible for the full $1,400 Recovery Rebate Credit on your 2021 tax return.

By putting aside money now so you can contribute at least $5,000 to a Traditional IRA for 2021 (assuming a retirement plan at work doesn’t cover you), which in this example would decrease your 2021 adjusted gross income to $75,000. This is an example of how a tax deduction can actually be worth more than usual because, in addition to the tax benefit for the deduction in and of itself, the deduction is also making you eligible for a credit that you wouldn’t be eligible for otherwise. Double tax win!

There are other ways to decrease your 2021 adjusted gross income to increase your 2021 Recovery Rebate Credit eligibility. For example, if you typically receive a holiday bonus, perhaps you can ask your boss if you can receive it in January 2022 rather than December 2021.

 

Tax Benefits for Education

If you paid for your own or a dependent’s education in 2021, you might be eligible for some tax benefits.

American Opportunity Credit

The American Opportunity Credit is a dollar-for-dollar credit available to those who pay qualified education expenses. To calculate the credit, you add the first $2,000 of qualified education expenses you paid for each eligible student during the year plus 25% of the next $2,000 of qualified education expenses paid for that student.

Mathematically, then, the credit reaches its $2,500 maximum once $4,000 of qualified educational expenses have been paid for a student.

Forty percent of the American Opportunity Credit is partially refundable, meaning that even if the credit completely wipes out a taxpayer’s tax liability for the year, they may still receive forty percent of the credit back as a refund. 

The American Opportunity Credit maxes out at $2,500, can’t be claimed for the same student for more than four tax years, and is phased out at the income levels shown in the table below.

 

Filing StatusPhaseout Begins (AGI)Phaseout Ends (AGI)
Single, Head of Household, or Qualifying Widow(er)$80,000$90,000
Married Filing Jointly$160,000$180,000

 

Suppose you have a 529 plan set up for yourself or your dependent, and you also meet the eligibility requirements for the American Opportunity Tax Credit. In that case, you’ll want to put some thought into how you pay for educational expenses in 2021.

Since you can’t take the American Opportunity Credit on the money you withdraw tax-free from a 529 plan, it might make sense for you to pay for at least $2,000 and possibly $4,000 of educational expenses from non-529-plan funds so you can take the American Opportunity Credit on those expenses.

 

Lifetime Learning Credit

Unlike the American Opportunity Credit, the Lifetime Learning Credit can be claimed for the same student for many years, hence why it’s called the Lifetime Learning Credit.

To calculate the credit, you simply multiply the number of qualified education expenses you paid for all students during the year (up to $10,000) by 20%. The maximum Lifetime Learning Credit a taxpayer can take during the year is $2,000. Unlike the American Opportunity Credit, none of the Lifetime Learning Credit is refundable; if you still have credit remaining after your tax liability for the year is wiped out, that excess credit is lost.

The Lifetime Learning Credit is phased out at the income levels shown in the table below.

 

Filing StatusPhaseout Begins (AGI)Phaseout Ends (AGI)
Single, Head of Household, or Qualifying Widow(er)$59,000$69,000
Married Filing Jointly$118,000$138,000

 

There are some potential planning opportunities with the Lifetime Learning Credit as well.

For example, suppose you aren’t in a rush to complete whatever degree you’re working toward. In that case, you could potentially limit your current year’s educational expenses to $10,000 to take the 20% Lifetime Learning Credit on all of them and then pay for $10,000 of expenses next year to maximize the credit next year as well.

 

Student Loan Interest Deduction

If you have student loans taken out for you, your spouse’s, or your dependent’s education, you may be eligible for the student loan interest deduction.

To qualify, the individual whose education the loan financed must be enrolled at least half-time in a program leading to a degree or other recognized credential. The definition of “half-time” varies from college to college and from university to university, so if the student isn’t currently taking a full class load, it might be worth it for them to confirm with their educational institution that they are in fact enrolled at least “half-time.”

If they aren’t enrolled at least half-time, they should consider increasing their course load to reach half-time status so they (or whoever claims them as a dependent) can benefit from the student loan interest deduction.

The student loan interest deduction maxes out at $2,500 and is phased out at the income levels shown in the table below.

 

Filing StatusPhaseout Begins (AGI)Phaseout Ends (AGI)
Single, Head of Household, or Qualifying Widow(er)$70,000$85,000
Married Filing Jointly$140,000$170,000

 

Educator Expense Deduction

Educators are allowed a deduction of up to $250 per year ($500 if married filing jointly and both spouses are educators) for unreimbursed expenses they incurred in doing their job.

Let’s say that you are a single educator, and by the end of 2022, you have to take some classes to maintain your credential. Although the cost of these classes is $500, your employer will not reimburse you for these expenses (but they do reimburse you for all other costs you incur in doing your job).

Rather than waiting until the last minute and paying all $500 worth of classes next year, perhaps you should take $250 worth of classes this year and the remaining $250 worth of classes next year in order to maximize your educator expense deduction.

If you pay all $500 of expenses in 2022, you will only be able to deduct $250 of them in 2022 but will not be able to make any deduction in 2021 because you did not have any unreimbursed educator expenses in 2021.

However, if you pay for $250 worth of expenses in 2021 and $250 worth of expenses in 2022, you will be able to take a $250 deduction each year for a total deduction of $500 across both years.

 

Child Tax Credit

The American Rescue Plan Act significantly increased and expanded the Child Tax Credit for tax year 2021.

While previously the Child Tax Credit was $2,000 for children up to the age of 16 with only $1,400 of the credit being refundable, the American Rescue Plan made the 2021 Child Tax Credit $3,600 for children up to the age of five and $3,000 for children between the ages of six and seventeen.

 While the income limitations for the “original” $2,000 portion of the Child Tax Credit have not changed — beginning at $400,000 for married taxpayers who file jointly and $200,000 for all other filers — the income limitations for the “new” $3,600 / $3,000 portion of the Child Tax Credit are much lower and are shown in the table below.

 

Filing StatusPhaseout Begins (AGI)Phaseout Ends (AGI)
Single or Married Filing Separately$75,000Depends on Number of Qualifying Children
Head of Household$112,500Depends on Number of Qualifying Children
Married Filing Jointly or Qualifying Widow(er)$150,000Depends on Number of Qualifying Children

 

Another change made to the Child Tax Credit for tax year 2021 is that a portion of the credit is now payable in advance.  Earlier this year, the IRS determined which parents were eligible for the 2021 Child Tax Credit and began making payments to them in July.  Payments will continue until December.

The amount of each monthly payment is one-twelfth of the total 2021 Child Tax Credit amount the IRS has deemed a print or parents to be eligible for based on their last-filed tax return.  Naturally, because the IRS does not know about children born in 2021 as they would not have yet been reported on a taxpayer’s tax return yet, the monthly payment amount will not include payments made for children born in 2021.

There are two major planning opportunities with respect to the Child Tax Credit.

The first planning opportunity has to do with determining whether or not you would like to continue receiving monthly payments from the IRS.  If you do not, there is an option on the IRS website to opt-out of receiving future monthly payments and instead claim your remaining Child Tax Credit amount on your 2021 tax return.

You may want to opt-out of receiving monthly payments of the 2021 Child Tax Credit, for example, if you typically “depend” on your tax refund as a forced savings account.  Although not ideal, and as a tax professional I would prefer that you have the money in your own bank or investing account throughout the year, I can understand why some taxpayers may want to get a large refund when they file their 2021 tax return rather than obtaining incremental deposits over the span of a few months.

You may also want to opt-out of receiving advance payments of the 2021 Child Tax Credit if you are receiving them but you know that your income will be over one or both Child Tax Credit phaseout amounts.  If this is the case, you may receive more in advance payments than the actual amount of the 2021 Child Tax Credit you are eligible for.

In this case, you may be required to pay back the difference between the monthly payment amounts you received and the actual amount of 2021 Child Tax Credit you are eligible for.  However, if your 2021 income is below the figure in the second column in the table below for your filing status, you may qualify for full repayment protection, meaning that you will not have to pay back any excess amount of the 2021 Child Tax Credit you received as monthly payments.

 

Filing StatusRepayment Protection
Phaseout Begins (AGI)
Repayment Protection
Phaseout Ends (AGI)
Single or Married Filing Separately$40,000$80,000
Head of Household$50,000$100,000
Married Filing Jointly or Qualifying Widow(er)$60,000$120,000

 

Even if you don’t necessarily opt out of the monthly payments in this situation, it’s still important for you to know that you may be required to pay a portion of the credit you received in advance when you file your tax return so you aren’t hit with a surprise tax bill when you file.

Also, it’s important for parents to keep in mind that Congress has not yet extended this expanded Child Tax Credit into tax years 2022 and beyond, though that has been suggested by some members of Congress as well as President Joe Biden himself.

 

Work-From-Home Benefits

While W-2 employees and 1099 freelancers alike used to be able to potentially take some tax benefits for working from home, the Tax Cuts and Jobs Act passed in 2017 eliminated these benefits for most W-2 employees.

Freelancers and other small business owners, however, still enjoy the ability to take several tax deductions for working from home.

Home Office Deduction

If you regularly work from home in an area exclusively used for your freelancing business, you are likely eligible to take the home office deduction for that area.

Calculating the home office deduction is simple: You simply multiply your housing costs (such as rent payments or mortgage interest, homeowners or renters insurance, property taxes, utilities, etc.) by the proportion of your living space used as your home office.

So let’s say you rent a two-bedroom, 1,000-square-foot apartment for $2,000 per month, which comes out to $24,000 per year.  You also pay $200 a year for renters insurance.  You incur no other housing costs so your annual housing expense is $24,200.

You sleep in the larger, 200-square-foot bedroom and use the smaller, 150-square-foot bedroom as your home office.  You work in this spare bedroom every day, and working is the only thing you do in this bedroom.  This last part is key — in order for a space to qualify as a home office, you must use it regularly and exclusively for your small business.  So working on your laptop in the bed you sleep in would not qualify your bedroom for the home office deduction.

In this example, you use 15% of your apartment as a home office (150 home office square feet / 1,000 total apartment square feet).  Multiplying 15% by your annual housing expenses of $24,200 gives you a $3,630 home office deduction.

The IRS also lets you use a simplified home office deduction method that involves simply multiplying the square footage of your home office by $5 per square foot (up to 300 square feet).  In this case, using this simplified method would only yield a home office deduction of $750 ($5 per square foot x 150 square feet), so you would be better off using the standard method.

Knowing this information about the home office deduction provides some planning opportunities.  If you don’t currently have a space you use regularly and exclusively in your small business, consider setting one up.  Even if you can’t spare an entire room, perhaps you could partition off a portion of a room and use that space regularly and exclusively in your business so it qualifies for the home office deduction.

And even if you do currently have a qualifying home office space, perhaps you can consider using a larger space for your home office in order to maximize your deduction.  In the example above, you may want to use the larger bedroom as your home office in order to increase your home office deduction and sleep in the smaller bedroom.

 

Automobile Expenses

If you have a home office and have to drive to meet clients, keep track of your mileage because it could save you quite a bit at tax time. Similar to the home office deduction, there are two ways to calculate your automobile expenses. The first (and more simple) way is to simply multiply the number of miles you drive during the year by the standard mileage rate for the year.  In 2021, this rate is 56 cents per mile.

Alternatively, you could divide the number of miles you drove your car for your business during the year by the total number of miles you drove your car total during the year.  The resulting percentage is your business use percentage for your car.

You can then add up all the actual vehicle expenses you incurred during the year such as gas purchases, repairs, maintenance, insurance, etc., and multiply the sum of these expenses by your business percentage for the vehicle.  Assuming you own (rather than lease) the car, you can also take a depreciation deduction on it if you use this actual expense method.

 


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