Americans are receiving rebate checks as part of the federal government’s economic response to the COVID-19 crisis—but in a few states, at least some of those checks could be taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. ed. Under the Coronavirus Aid, Relief, and Economic Security (CARES) Act, up to $1,200 rebates are provided for individuals ($2,400 for joint filers), with an additional $500 for each qualifying child, with the benefit phasing out for higher earners. Designed as a refundable tax creditA refundable tax credit can be used to generate a federal tax refund larger than the amount of tax paid throughout the year. In other words, a refundable tax credit creates the possibility of a negative federal tax liability. An example of a refundable tax credit is the Earned Income Tax Credit. , they do not constitute taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. at the federal or state level. But due to a quirk of some tax codes, they could increase your income tax liability in six states: Alabama, Iowa, Louisiana, Missouri, Montana, and Oregon.
The structure of the rebate has generated some confusion, so while my colleagues have developed an entire FAQ around this and other provisions of the CARES Act, a quick explanation is in order here. Technically, these rebates are a refundable tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. for tax year 2020 (the tax return you file in April 2021). However, they are being paid out in advance based on your most recently filed tax returns (2018 or 2019 tax year) to get them to you immediately. It is not an advance on any existing credit, or on your 2020 tax refundA tax refund is a reimbursement to taxpayers who have overpaid their taxes, often due to having employers withhold too much from paychecks. The U.S. Treasury estimates that nearly three-fourths of taxpayers are over-withheld, resulting in a tax refund for millions. Overpaying taxes can be viewed as an interest-free loan to the government. On the other hand, approximately one-fifth of taxpayers underwithhold; this can occur if a person works multiple jobs and does not appropriately adjust their W-4 to account for additional income, or if spousal income is not appropriately accounted for on W-4s. ; it’s a new credit, tied to 2020 taxes, being paid out in advance.
The credit phases out at higher incomes, so if someone’s income is lower in tax year 2020 than it was in the tax year on which their initial rebate was calculated, they can claim the residual amount on their 2020 tax return. Similarly, families grow: some people will have children to claim on their 2020 tax returns that weren’t around to be claimed previously, entitling them to a larger benefit. Here too, the difference can be claimed as a refundable credit in 2020. Importantly, no one has to return any of the money if it turns out they would have been eligible for less of a rebate using 2020 income than they were based on the 2018 or 2019 income with which their relief was calculated.
When you get a check this year, it doesn’t reduce your tax liability. It is best understood as completely separate from any tax calculations. If, however, you have an additional amount to claim next year, that residual amount comes in the form of a tax credit that reduces your income tax liability for the 2020 tax year. (If you have no tax liability, or less than the amount of your residual rebate, refundability means that you receive a check for the difference.) And that’s where it gets tricky in those six states.
Each of these states, to varying degrees, offers a deduction for federal taxes paid. When you calculate your taxable income for state income purposes, you subtract the amount you owe in federal taxes. This is already a peculiar policy, as it essentially turns state income taxes into the mirror image of the federal code: things that increase your tax liability at the federal level reduce your state income tax liability, and vice versa. Taking a federal child tax credit, for instance, means that you pay more in state taxes. (You still benefit overall; the federal savings are larger than your additional state tax burden.) And having more of your income fall in a higher federal income tax bracketA tax bracket is the range of incomes taxed at given rates, which typically differ depending on filing status. In a progressive individual or corporate income tax system, rates rise as income increases. There are seven federal individual income tax brackets; the federal corporate income tax system is flat. lowers your effective rate at the state level.
All of these states would be better off raising the same amount of revenue with lower rates but no federal deduction, and both Iowa and Missouri have recently taken steps in that direction. Iowa’s deduction sunsets in a few years (paired with rate reductions) and Missouri’s is now phased out for higher income earners as part of last year’s rate reforms. But so long as they exist, in those states or the four others, they now have a new consequence: any residual amount of the rebate you claim on your 2020 taxes will, by virtue of reducing your federal income tax liability, increase the amount you pay to your state.
|State||Federal Deductibility Provisions|
|Missouri||$5,000 deductibility cap with income phaseout|
|Montana||$5,000 deductibility cap ($10,000 joint filer)|
|Oregon||$6,800 deductibility cap with income phaseout|
Source: State statutes; state revenue departments; Tax Foundation research.
It’s doubtful that any of these states intend to tax your rebate. To prevent that from happening, though, lawmakers will have to exempt it. And, even if it’s postponed for a later date, perhaps that can prompt a broader conversation of why federal deductibility still exists at all.
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