Withholding Checkup

The IRS recently launched a campaign urging taxpayers to conduct a paycheck checkup and review their withholding settings in light of the new tax law. To quote from the IRS:

The Tax Cuts and Jobs Act, passed in December 2017, made significant changes, which will affect 2018 tax returns that people file in 2019. These changes make checking withholding amounts even more important. These tax law changes include:

  • Increased standard deduction
  • Eliminated personal exemptions
  • Increased Child Tax Credit
  • Limited or discontinued certain deductions
  • Changed the tax rates and brackets

Checking and adjusting withholding now can prevent an unexpected tax bill and penalties next year at tax time. It can also help taxpayers avoid a large refund if they’d prefer to have their money in their paychecks throughout the year. The IRS Withholding Calculator and Publication 505, Tax Withholding and Estimated Tax, can help.

Special Alert: Taxpayers who should check their withholding include those who:

  • Are a two-income family.
  • Have two or more jobs at the same time or only work part of the year.
  • Claim credits like the Child Tax Credit.
  • Have dependents age 17 or older.
  • Itemized deductions in 2017.
  • Have high income or a complex tax return.
  • Had a large tax refund or tax bill for 2017.

Withholding doesn’t seem like it should be complicated, but it really is. You may think that your employer could just apply your tax rate based on your fully year salary to your pay each period and voilà, done. But your employer doesn’t know your mortgage interest or property taxes for deduction purposes. They don’t know your bonus in advance (and by the way, they use a completely different rate on bonus income in most cases too!). They don’t know what tax credits apply to you. They don’t know your spouse’s salary. They don’t know your investment income or any other special circumstances that lead to an increase in income, deductions, or credits. We account for all those things by setting the “allowances” and the extra amount withheld per pay period on your W-4 so that it MacGuyer’s the system into something close to the right amount of tax over the course of a full year. With all the changes to the tax rules this year, the mid-year implementation, and some still unclear tax rules that are awaiting IRS guidance, well… it reminds me of MacGuyver without access to duct tape.

Here’s the good news… In most cases, underwithholding will simply lead to delaying the same amount of tax you would have paid during calendar 2018 to the time you file for 2018. That is, the total tax you’ll pay will be the same whether you pay it during the tax year or at the time of filing. Partial interest could be charged if you owe a substantial amount and the total amount that you had withheld during the year is less than 110% of your total tax liability for 2017. Overwithholding will of course result in a refund at the time of filing. In other words, getting withholding exactly right is not a huge deal for most people. We just want to get it close so that we’re not surprised by a large tax bill in April or a large refund (which means you provided the government with an interest-free loan all year),

If you are concerned about your withholding and want help conducting a paycheck checkup, please contact your advisor. Send a recent paystub for each earner in the family, the final paystub for any employment that may have ended earlier in the year, and an estimate of the regular pay and (if applicable) bonus pay that you’ll receive for the remainder of the year. Using last year’s deductions, the new tax laws (our understanding of them), and the pay information, we should be able to figure out if you’re in the ballpark on withholding, or if you should make some adjustments to avoid a big shock in April.

2018 Federal Withholding

In January, the IRS released new withholding tables for employers to begin using by the end of Feb 28. These new tables will take into account the new tax rates under the Tax Cuts & Jobs Act (“TCJA”) and will reduce the amount of tax withheld from your paycheck in most circumstances. However, your W-4 on file with your employer determines how many allowances are used as part of the withholding calculation and how much additional tax you elected to have withheld. Those allowances reflect a combination of your expected deductions that exceed the standard deduction (if you itemize), the number of members of your family (exemptions), the impact of multiple earners filing jointly (marriage penalty), and the impact of certain credits based on your total expected income and family size. Because the rules for many of those items have changed under the TCJA, it is very possible that the number of allowances that you are claiming is no longer correct, meaning that the withholding calculations will not be accurate.

The IRS is revising the W-4 form and their online withholding calculators to reflect the changes, but they’re not expected to complete that task for at least a few more weeks. Until then, once your employer starts using the new withholding tables, you should be aware that too little (or in some cases) too much tax will be withheld. This will accrue a refund or an amount owed in April 2019 when you file for 2018, which may result in a higher or lower refund or amount owed than you are used to seeing. Assuming the new W-4 is released by the time your 2017 taxes being prepared, you should work through the new withholding settings and file a new W-4 with your employer at that time. A month or two of inaccurate withholding will result in a smaller impact on your April 2019 tax refund / amount owed than multiple months will. I will be initiating this conversation with financial advising clients for whom I prepare taxes. If you’re preparing your taxes on your own or through another preparer, make sure to consider a W-4 revision if appropriate. Contact your financial advisor if you’re not sure what to do.

Withholding On Bonuses & Other Supplemental Wages

When you receive a bonus from your employer, have restricted stock vest, have taxes collected on the cashless exercise of a stock option, or receive any other form of supplemental wages, you may have too much or too little tax withheld depending on your marginal tax bracket and the method your employer uses for tax withholding. On a normal (non-bonus paycheck), payroll withholding tables take the amount of taxable income you earn for the pay period and translate that to the amount of tax that should be withheld, using the marginal tax brackets for your filing status (from your W-4), the number of allowances you claim (from your W-4), and number of pay periods in a year. For example, if you claim “Single, with 0 allowances”, you earn $8k in a pay period, and you are paid bi-weekly (26 x per year), the withholding tables will determine the projected annual tax liability based on the Single tax brackets, $8,000 * 26 = $208,000 of projected taxable income for the year. Dividing by 26 gives the Federal withholding amount for the pay period.

From the example above, you should be able to see how wildly the withholding rate can vary if your paycheck varies from period to period, which is why it is so hard to accurately set your withholding and why you never seem to get the same refund or owe the same amount year after year. (Add in exemptions, deductions, and credits, and it gets even more difficult). If you receive bonus pay as part of your regular pay, your employer can combine the two and determine the withholding on that paycheck based on the extrapolated annual income if you earned that amount each pay period. In this case, your projected annual income and the withholding tax rate will be very high because 26 * your combined wage and bonus is a very large number. You’d therefore have more withholding than is necessary for the period and would accumulate that amount toward a tax refund when you file. The more typical scenario is that your bonus would be paid either as a separate paycheck, or as a separate line item on your regular paycheck but considered as supplemental wages. In both of these cases, a statutory 25% withholding rate is used for the supplemental wages. If your marginal tax bracket is actually higher than 25% (taxable income over about $90k as a single filer, or over $150k as a married couple), then you’d have less withholding than is necessary for the period. That would accumulate toward an amount you’d owe when you file your taxes. In an extreme example, let’s say that you earn $250k per year as a single filer (33% tax bracket), but that you have an windfall of an additional $250k (bonus, stock, whatever). That $250k windfall is taxed at 25% when it should be taxed at ~35%, meaning you’d stand to owe $25k in tax when you file for that tax year.

The moral of the story is to be careful whenever you receive a bonus (or earn some other form of supplemental income like vesting equity). If the following conditions exist, it may cause you owe a substantial amount of tax at the end of the year:

1) It is paid in a separate paycheck, as supplemental wages on your normal paycheck, or withheld automatically as part of an equity transaction

2) You earn more than $90k per year (single) or $150k per year married, including the bonus payment.

Note that the tax is the same whether it is appropriately withheld at the time of the bonus payment or if you pay it at the end of the year. The problem isn’t that you pay additional tax. The potential problem is that you may owe a lot of tax and may not have been prepared for it (e.g. you used the bonus for a downpayment on a house or to payoff debt, and don’t have the cash remaining to pay your tax). It’s always a good idea to keep 10-15% of your gross bonus tucked away to make sure you have it available for taxes if needed. If you need a more detailed estimate of the potential tax impact of a large bonus payment, contact your financial advisor.