Families Might Soon Discover Smaller-Than-Expected Tax Refunds

By Liz Weston

Families battered by the pandemic recession soon may discover that the tax refunds they're counting on are dramatically smaller - or that they actually owe income tax. Congress offered a partial solution, but the fix hasn't been widely publicized, consumer advocates say.

Refunds are crucial to many lower- and moderate-income households, which use the money to catch up on bills and medical treatments, pay down debt and boost savings.

But the unemployment insurance that kept many people afloat last year may cause problems at tax time this year. Unemployment benefits are taxable, but tax withholding is typically voluntary - and many people who lost jobs either didn't know their unemployment checks would be taxed, or they decided against withholding. (Relief checks, such as the $1,200 sent out last year, are not taxable.)

Further, unemployment benefits are not earned income and so don't count toward two crucial tax benefits that keep millions of working families with children out of poverty: the earned income tax credit and the additional child tax credit.

"If you're a single parent or a couple with kids living on, say, $25,000 a year, you might see 25% or more of your annual income in the form of your federal tax refund because of these credits," says Timothy Flacke, executive director of Commonwealth, a nonprofit that promotes financial security.

THERE'S A FIX ON CREDITS, BUT NOT ENOUGH PEOPLE KNOW ABOUT IT

There isn't an easy workaround for tax refunds shriveled by inadequate withholding. But Congress provided a potential fix for the tax credits issue in the $900 billion coronavirus relief legislation passed last month: Filers can choose to use their 2019 income to determine their credits rather than their 2020 income.

But that fix hasn't been widely reported, says Leigh Phillips, chief executive officer of SaverLife, a nonprofit that encourages working families to save. Not everyone uses up-to-date tax software or well-informed tax preparers, and Phillips worries that many eligible people won't learn about it before filing their returns. The IRS will begin accepting returns Feb. 12.

"People are going to start trying to file taxes as soon as they possibly can," Phillips says. "If you think that you've got thousands coming in the mail or to your bank account, you're there day one with your paperwork ready to go."

THOSE WHO RELY ON REFUNDS TEND TO FILE EARLY

Research confirms that the earliest recipients of refunds each year tend to be lower income, says Fiona Greig, co-president of the JPMorgan Chase Institute, which studies data from millions of customer bank accounts.

"(A tax refund) tends to be a larger relative cash infusion event for them, and as a result, they tend to seek their refund earlier in the tax refund season," Greig says.

In typical years, tax refunds equal almost six weeks' take-home pay for the average recipient, the institute found. Last year the average refund was more than $2,500.

Families who qualify for the earned income tax credit can receive thousands more. The maximum credit for working families with three or more children is $6,660 for 2020, and it's refundable, which means filers get the money even if they don't owe any tax.

The amount you can earn and still qualify rises with family size, so that a married couple with three or more children could get at least a partial credit with adjusted gross income up to $56,844. A single person without children may qualify for a small credit with an adjusted gross income up to $15,820. Meanwhile, the regular child tax credit for children under 17 is $2,000 and not refundable. But low-income families may qualify for a refundable credit, which can be up to 15% of earned income over $2,500, up to $1,400 per child.

Liz Weston is a NerdWallet columnist

TAX CREDITS HAVE WIDESPREAD SUPPORT

The credits have been around for decades and have widespread bipartisan support among lawmakers, Commonwealth's Flacke says.

"It's one of the few areas of some consensus across the parties that rewarding workers on the low end of the wage spectrum with these tax credits makes sense," Flacke says.

If you might qualify for one of the tax credits, make sure your tax software or tax preparer looks at both your 2019 and 2020 incomes before submitting your return. If you find out too late that you could have received a bigger refund, you can file an amended return, but you may face a longer wait. Instead of getting your refund in a few weeks, an amended return can take up to four months to process.

Going forward, President Joe Biden has proposed one-year expansions of the credits as part of his coronavirus relief package. He wants to increase the maximum earned income tax credit for childless adults from $538 to nearly $1,500 this year and to raise the income limit. He also wants to increase the child tax credit to $3,000, plus an extra $600 per child under age 6, and make the full amount refundable. If enacted, these credits could be claimed on returns filed in 2022.

Liz Weston is a columnist at NerdWallet, a certified financial planner and author of "Your Credit Score." Email: [email protected]. Twitter: @lizweston.