Many people are celebrating the fact that tax reform might lower their income tax liability. What is lost in the celebration, however, is this related, but separate, question, "Will I get a refund next April?"
Many people think that a lower tax liability equals a refund next April. Unfortunately, that is not always the case. In fact, if you haven't adjusted your withholdings, you could actually end up owing the IRS money instead. Surprise!
Most workers and retirees rely on tax withholdings to properly pay the federal and state tax owed on their income. These people typically just roll over their withholdings year after year with little review. If this applies to you, let these words be your wake-up call to review your situation now. While the new tax laws may reduce the amount of tax you pay, there is an uncomfortably high possibility that you may still end up having to pay a balance due on April 15, 2019.
Take a look at your tax withholding today
Most people "set it and forget it" when it comes to tax withholdings. That is, until some major life event comes along, like getting married, buying a house, having children, getting a promotion or inheritance or losing a spouse.
But the Tax Cuts and Jobs Act (TCJA) was a major overhaul to the previously consistent tax laws we had all grown accustomed to over the last 30-plus years, and those tax changes could affect the amount you should be withholding. Key changes to the new laws include:
- Tax rates were largely reduced, and income tax brackets were expanded.
- The standard deduction nearly doubled from $12,700 to $24,000 for married couples filing jointly and $6,350 to $12,000 for single individuals.
- The deduction for state and local income and property taxes is capped at $10,000 for both married couples and single individuals.
- Personal exemptions were eliminated.
- The child tax credit doubled from $1,000 to $2,000 per child, and the phase-out limitations were increased from $110,000 to $400,000 (for married couples filing jointly).
So now we have lower rates in bigger brackets, but fewer deductions, no exemptions, yet bigger credits. How does that all add up?
The Tax Policy Center estimates that 67% of taxpayers will owe less tax, 25% of taxpayers will have no change in their tax, and 7% of taxpayers will owe more tax. Combined, that means that 92% of taxpayers will be winners or net neutral on tax reform. But that does not automatically equate to getting a refund next April!
Whether or not you'll get a refund is dependent on how much tax you pay from withholdings and estimated payments. Since the IRS updated withholding tables to reduce withholding after the TCJA passed, between one-third and one-half of taxpayers may potentially end up with a balance due with their tax return next April.
Withholding for workers and retirees is different
For workers, income tax withholding is calculated by your payroll department using withholding tables maintained by the IRS and your Form W-4 on file with your employer. When the TCJA was passed, the IRS updated these withholding tables to reflect the new law so that you wouldn't need to update your Form W-4. When doing so, however, the amount withheld was generally decreased to account for the lower tax rates and expanded brackets. This lower withholding, in combination, with the loss of many itemized deductions means that workers (especially those with higher incomes) are more likely to be under-withheld. And that could mean they will be writing a check to the IRS come April.
For retirees, the most common withholding that occurs is from retirement account distributions, pensions and Social Security.
Retirement account withholding is not subject to the same withholding tables as employees. Generally, a fixed percentage of a distribution or set dollar amount is set and withheld from any retirement account distributions. If you have recurring distributions that have withholding, the amount will not have automatically changed, therefore, you are less likely to be underpaying your taxes. Meaning that you'd be less likely to owe the IRS come April 15, 2019.
Pensions are subject to the same withholding tables as any other income source. Because of this, retirees who have large pensions and have taxes withheld may encounter the same problem as working employees. You can adjust the withholding on your pension to increase the amount of taxes taken out by providing an updated Form W-4P to your pension provider.
Social Security withholding is not subject to the same withholding tables as employees. Instead, Social Security recipients complete Form W-4V to instruct the Social Security Administration to withhold either 7%, 10%, 12% or 22% of their benefit as federal tax. Flat dollar amounts are not accepted. Before the TCJA, the withholding rates were 7%, 10%, 15% and 25%. If you previously elected one of these percentages, they will continue to occur until you file a new Form W-4V, therefore, many retirees will be less likely to be underpaying their taxes.
How can I avoid withholding problems?
A balance due and potential underpayment penalty can be avoided with a simple check of your withholding. And it's easier than you think.
The IRS created an online withholding calculator to help taxpayers estimate their withholding under the new law. All you need to get started is a copy of your most recent paycheck and your most recent tax return. The tool helps to estimate your 2018 income and compare it to your current withholding. This allows you to determine if you will be over- or underpaid, and it even lays out how many exemptions you should claim for the remainder of the year in order to avoid a tax withholding problem.
Remember, good tax planning keeps more money in your pocket. Be smart about tax planning and end up with a small refund or balance due. If a change is warranted, you'll need to fill out a new W-4. Generally, if you need to increase the amount of money that's being withheld from your income, you'll want to decrease the number of allowances you claim. If you want to decrease your withholding, you would increase the total allowances.
In general, paying tax via withholding can be more effective than making estimated tax payments to avoid underpayment penalties. Estimated payments are only credited during the quarter they are paid, while withholding is deemed to have occurred equally over the course of the year, even if it doesn't happen until the fourth quarter. So, for those of you who are underpaying your taxes, setting up larger withholdings between now and the end of the year may effectively solve your problem.
For individuals with more complex tax situations, however, I highly recommend consulting a tax specialist to discuss any changes you may need to make regarding tax reform.
Be Tax Smart
A natural consequence of comprehensive tax reform is the mechanics of actually calculating the tax. While the IRS tried to simplify this for workers, it's not possible to address every situation. This means that taking a second look at your withholding will be especially beneficial for higher-income earners, dual-income families, residents of states with high income/property taxes, people who previously itemized their deductions and families with children.
If you have any questions about tax withholdings, tax law changes or your own tax situation, talk to a tax professional who can help you navigate and ask the following questions to take advantage of our continually changing tax landscape:
- Should I start/increase withholding on income sources that previously did not have withholding?
- Do I need to make estimated tax payments or increase my withholding so I don't have a "tax surprise" next April?
This information is not intended to be a substitute for specific individualized tax advice.
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