Many people were caught off-guard when they filed their 2018 tax returns and discovered that they owed tax when they had received refunds in recent years. The withholding tables used by employers to determine the taxes withheld from paychecks were changed for 2018 as part of the Tax Cuts and Jobs Act (“TCJA”) which passed in late 2017. Most employees welcomed the additional take-home pay that resulted from the tax cut,s but were unaware that the reduced withholding during the year was more than the actual tax liability reduction they were entitled to. Thus, the nasty surprise come tax filing season.
If you didn’t update your withholding for 2019, you may owe again this year. How can you avoid this cycle and get back to the good old refund days? Is there a better way?
January is a great time to revisit the taxes withheld from your paycheck. It’s even more important if you or your spouse changed jobs or modified your employment during the year, or if you purchased a home or had some other major life event.
How do I know if enough tax is withheld from my pay?
One great way to determine if your tax withholding is at the correct level is to use the IRS’s online tax withholding estimator tool - https://www.irs.gov/individuals/tax-withholding-estimator. The tool steps you through a series of questions to determine if you need to change your current withholding, and will populate a new W-4 form for you to give to your employer to make the change. You will want to have a copy of your most recent paystubs and access to your most recent tax return filing before you get started.
Why is this even important?
No one likes surprises and it’s difficult to owe taxes in April when you aren’t expecting it. You may not have extra money laying around. If you aren’t able to pay the taxes due by the deadline, you may incur significant penalties and interest until the tax is paid. But if you know in advance how much you will owe, you have time to set aside funds.
What are the requirements?
The U.S. tax system is a “pay as you go” system, and taxpayers are expected to pay in at least 90% of their current year tax liability during the year. Your employer withholds the tax from your paycheck and then remits it to the IRS on your behalf throughout the year. Then you file your tax return to “settle up” and you either get a refund or owe more tax. The deadline to file personal tax returns is April 15 of the following year. You are allowed to request an extension of time to file your returns to October 15. A common misperception is the extension is also an extension of time to pay your taxes too. Not true. The balance of your taxes are due on April 15, and if you owe additional tax when you file on extension, you will pay interest and possibly some penalties depending on how much you owe.
When you owe additional tax on April 15, no penalties or interest will be assessed if you pass the safe harbor test. In the safe harbor test, if you paid in at least 90% of your current year tax liability OR 100%/110% of your previous year tax liability during the year, then you won’t also owe any interest or penalties on April 15 – even if your income has increased dramatically and you owe a lot.
There are additional rules for self-employed people that we will discuss in a future article.
What if I expect my tax liability to be $0?
You can request an exemption from withholding for the current year if you received a refund of ALL of your withholding in the prior year because your tax liability was $0 AND you expect to have no tax liability for the current year too. It’s common for students to qualify for an exemption from income tax withholding.
If you have any questions or require assistance in determining if your current withholding needs updating, please reach out to your HPG tax professional who will be happy to assist you.