Payroll Withholding – Time for a Reality Check

After sweeping tax reform by Congress in December 2017, the Internal Revenue Service (“IRS”) rushed to update the tax withholding tables used by employers and payroll services to determine the amount of Federal income tax to withhold from employees’ paychecks.  With many changes expected to positively impact the average taxpayer, namely lower tax rates, higher standard deductions and larger Child Tax Credits, the goal was to quickly increase take home pay.  Many employees noticed an increase in their paychecks in February as employers started using the new IRS withholding rates.

Purpose of withholding tables

The objective of the IRS withholding tables is to not have taxpayers owe money at the end of the year.  Employers use the withholding tables in combination with the information on your Form W-4 (remember that form you filled out on your first day of work?) to calculate the amount of tax withheld from your paycheck.  Ideally you should “break even”.  After the tax tables reflecting the Tax Cuts and Jobs Act were released there were some reports of the withholding rates being set artificially low, thereby increasing employees’ take home pay by too much which they would have to pay back when they file their 2018 tax returns.  That would be a problem for many taxpayers since it’s estimated that nearly 80% get a refund and enjoy this form of forced “savings”.

The other problem with having too little withheld from your paycheck is the potential of paying a penalty on top of the tax you owe.   This penalty kicks in if you fail to pay at least the smaller of:

• 90% of your current year tax total tax, or
• 100% of the total tax on your previous year tax return (if your Adjusted Gross Income on line 37 was more than $150,000 ($75,000 if married filing separate), the percentage increases to 110% of prior year tax.)

Check your paycheck

Many individuals are uncertain how the tax law changes will affect them and their yearend tax bill.  Doing a mid-year paycheck review is a great idea while there is still time to adjust your payroll withholdings.  A simple, easy tool to use for this exercise is the IRS’s withholding calculator.  This tool was updated and released earlier this year.  The calculator works best for individuals and families with W-2 income and little or no dividends and capital gains, in other words employees whose investments consist  primarily of retirement assets such as 401(k), 403(b), IRA, Roth IRA and Profit Sharing accounts.  To start the process you will need to gather your most recent pay stubs showing current and year-to-date amounts and your most recent income tax return.

After just a few minutes of guided data entry the calculator shows your results.  It compares your anticipated income tax for 2018 with the amount of projected withholding, the net of which results in either an overpayment (refund) or balance due.  If there is a projected balance due, the calculator tells you how to complete a new  Form W-4 to adjust your withholding.  Likewise, if there is a projected refund, it recommends how to adjust your withholding so you can increase your take home pay now rather than letting the U.S. Treasury borrow your money interest free.

Special situations

If you are single now but will be married by December 31, you and your future spouse will file a tax return as married filing jointly or married filing separately.  (Your marital status on the last day of the year determines your tax filing status.)  These individuals should check their withholdings together assuming one of these filing statuses.  And for those individuals and families with more complicated tax situations, like income from a pass-through business (Schedule C, Partnership, LLC or S Corporation) or significant amounts of investment income, it’s best to consult with your tax advisor rather than relying on the IRS withholding calculator.

If you decide to change your withholdings for the rest of this year, you should submit a new Form W-4 to your employer at the start of the new year.  It’s always recommended to complete a new W-4 for your employer when you experience a life change like marriage, divorce or arrival of a new dependent.