A couple came into my office to discuss their tax return results last week. For 2018, their income had jumped $15K, but their federal income taxes remained about the same as in 2017. Good news, right?
Unfortunately not. Their federal income tax withholding went down $2K turning a $1,000 refund in 2017 into a $1,000 balance due in 2018.
“But we always get a refund!”
I spent 15 minutes trying to convince them that they were better off tax wise in 2018 than 2017 – that they had actually gotten a tax cut.
Too many people evaluate their tax situations based on the size of the refund or balance due. As my business partner, Paul Karstetter, has explained many times, “I can get you a million dollar refund every year. Just over pay your taxes by a million dollars.”
I have reviewed a number of tax returns prepared by people on their own using free or low cost software. They call me when the software tells them that they owe 5 figures to Uncle Sam. Here’s how this happened in 2018 and will again in 2019 unless they take some action.
A couple making $250K had $25K in federal withholding for 2018. They’re surprised to hear that they owe more than $20K. I’m surprised that’s all they owe. $25K divided by $250K is 10%. Their federal tax withholding was only 10% of their income. That doesn’t work – at least if you hope to get a small refund or small balance due.
The couple’s marginal federal tax rate after deductions, at $250K in income, is probably 24%. That’s the marginal rate, not the average rate, but you don’t need to do a lot of math to figure out that 10% withholding isn’t going to get the job done. Here’s how they (and you) might take the 2018 results and create a happier 2019.
Take line 15 from your 2018 tax return, total taxes, and divide that by total wage, pension, and IRA income, lines 1 plus 4. Those items of income are normally the ones with tax withholding. This percentage is the percentage of wage, pension, and IRA income that must be withheld to not owe a balance to Uncle Sam at the end of the year.
If your income from those categories is $250,000 and your line 15 federal taxes are $47,500, your withholding percentage must be 19% to not owe federal taxes. This isn’t your marginal tax rate or your average tax rate. It’s the rate of withholding on your income that you must achieve to not owe taxes.
To make 2019 a better year, take your latest paystub or pension payment, and divide your federal withholding by the taxable income from the stub. Before dividing, reduce your gross pay by tax deductible items such as 401(k) and health insurance deductions. If your percentage from 2019 is lower than the percentage from your 2018 tax return, LOWER your exemptions until you get to the 2018 percentage.
How many exemptions should you eliminate? I have no idea. It will be different for everyone and might be a fine reason to call a tax professional.
What happened to cause so much pain for so many in 2018? As part of the tax reform act, the IRS was instructed to lower tax withholding to give people their tax cuts during 2018, instead of waiting for bigger refunds at tax return filing time. The IRS was a little too generous. Wrap your head around that. The IRS gave people too much money back.
The IRS isn’t at fault. They were directed to reduce withholding. One might say it was a political decision to boost the election chances of a certain political party. I won’t say that, and we all know how that worked out anyway.
In my experience, the people, who got really stuck with big balances due, were claiming five or more exemptions with $150K plus in income. That worked with the old tax law, but not now.
What should you do if you owe a lot of money to Uncle Sam? First, don’t take the money out of your IRA or 401(k) plan. With taxes and potential early withdrawal penalties, you’ll just dig a bigger hole in 2019. Don’t call a tax resolution firm. They’ll reduce your bank account by $5K to $10K and may do nothing at all, leaving you still owing the IRS.
Download form 9465 from www.irs.gov. Use this form to request a payment plan from the IRS. You don’t even have to talk to them. If you propose paying off the balance in less than three years, the IRS will automatically accept your offer.
If you have questions or would like more information, call Stitely & Karstetter, CPAs at 703-818-8284 or e-mail email@example.com. Thanks for reading and Happy Tax Season! Let’s share an adult beverage after April 15th!