That howling wind-like sound you heard at midnight on Monday, April 15 was accountants across the country exhaling at the end of what has been one of the most trying tax seasons many CPAs have ever worked through. The 2018 tax season has been particularly hard on accountants because, in addition to all of the data gathering and return preparation work that they do every year, this year many of them have had to serve another role: the bearer of really bad financial news. Taxpayers across the country have been surprised with their tax obligations under the Tax Cuts and Jobs Act and it is likely their CPAs who are explaining this system to folks for the first time. Today’s post will focus on some of the root causes of these tax surprises and propose a solution or two for those who owe more than expected.
The first reason taxpayers have been surprised this April has to do with the withholding tables used by the IRS. These tables, which work in conjunction with the information you provide on your W-4 form, were updated when the tax law was passed 15 months ago. The IRS spent much of 2018 issuing notices to taxpayers to let them know that they ought to check their withholdings based on the new rates and tables. Many of the taxpayers who heeded the IRS’ advice were surprised to find that their previous withholding was insufficient based on their circumstances and they updated their withholdings accordingly. Those who did not check their withholdings are among the people having uncomfortable conversations with their CPAs this spring.
There are several reasons the changes in the withholding tables may have resulted in the under-withholding of federal income tax for many families. These factors include the doubling of the standard deduction, the end of personal exemptions, and the elimination of many deductible business expenses (among others). Even individually, each of these changes may have added to families’ tax liability; when folded together (and then combined with the profound changes to the deductibility of state taxes, which we’ll cover shortly), the result is an unprecedented level of unpredictability in withholdings.
The under-withholding of federal income tax is frustrating when you have earned income, but it is truly maddening when you have phantom income – that is income that you must recognize on your return, but which you did not realize in the traditional sense. A common example (and one whereby under-withholding hurt a lot of people in 2018) is the vesting of Restricted Stock Units (“RSUs”). RSUs are taxable as ordinary income when the shares vest, not when they are sold. For individuals who had RSUs vest in 2018, federal income tax was often under-withheld (due, in part, to the IRS tables) and the bill is now due for additional income tax even though the shares have not been sold.
The final reason taxpayers may be surprised is one that has received a great deal of press over the last 12 months, but whose implications are now only becoming clear as returns are filed: the implementation of a $10,000 cap on deducting state and local taxes. In the past, taxpayers in states that assess income taxes (often in the neighborhood of 9%) received a sizable federal income tax deduction for these state income tax payments. This deduction, when combined with deductions for some medical expenses, mortgage interest, charitable gifts, and some (now eliminated) miscellaneous expenses, resulted in substantial itemized deductions under the old federal tax code. The cap on this deduction has left families with lower itemized deductions, often significantly. In many cases, the concurrent drop in tax rates has resulted in a negligible difference in tax liability. In other cases, however, the impact has been profound.
What can you do to avoid trouble in the 2019 tax year if you owe a lot in taxes for 2018? The first thing to consider is adjusting the W-4 on file with your employer. If you expect your 2019 earnings to be similar to your 2018 earnings, then adding an additional withholding (equal to the amount you owe on your 2018 taxes divided by the number of times you expect to be paid in 2019) in line 6 of your W-4 (titled “Additional amount, if any, you want withheld from each paycheck”) should do the trick.
You may also want to consider increasing your retirement plan contributions. If your employer offers a 401(k) or other qualified retirement plan, then contributions to these accounts will have the effect of reducing your taxable income for 2019 and shifting the tax burden to the year in which you withdraw funds from these accounts. You can also shift income tax in this manner if you are able to make deductible contributions to an IRA. The 401(k) limit for employee contributions is $19,000 in 2019 (with an additional catch-up contribution of $6,000 available for employees over the age of 55), while the IRA limit is $6,000. It is important to note that contributions to Roth accounts (401(k) or IRA) are not tax-deductible and will therefore have no impact on your 2019 taxable income.
There are several other ways in which taxpayers may be able to reduce their taxable income in 2019. If you find yourself saving for education expenses or medical costs, then you may be able to reduce your taxable income by making deductible contributions to a 529 plan or a health savings account.
No one enjoys tax surprises and the best way to avoid them is to plan accordingly. We’re happy to discuss these and other planning issues with you if you received some unwelcome news this tax season.