This year was the first-time taxpayers filed returns under the new tax law. There was a lot of information (and misinformation) in the news leading up to the official opening of the 2019 filing season and the frequency of news stories has continued. We've had many clients receive a bit of a shock when given the results of their 2018 return. Many were pleasantly surprised by a larger than normal refund or, for some, their first refund in a long time. For others, however, the new tax law resulted in a smaller than normal refund, a balance due for the first time, or a larger than normal (or larger than expected) balance due. I want to help shed some light on the possible causes of these surprising results and help explain the steps you can take for a preferable outcome next year.
First, a quick overview of the changes affecting the largest percentage of taxpayers (i.e. changes to the standard deduction, reduction in withholdings, and loss of the personal exemptions).
- Standard deductions were increased significantly from $6,350 to $12,000 (single), $12,700 to $24,000 (married filing jointly), and $12,200 to $18,350 (head of household). On your tax return, you can take a standard deduction or the sum of your itemized deduction – whichever is higher.
- A new withholdings table was introduced under the tax law resulting in the automatic reduction of withholdings. This is the “more money in your paycheck” part of the new law. This means that the amount of money being withheld for tax purposes from paychecks and retirement distributions generally dropped unless you requested a change to your withholdings.
- Personal exemptions are gone ($4,050 per person). There are no exceptions!
- Changes to tax brackets resulted in an overall decrease in the tax liability for many tax payers.
*There are MANY other changes, but these are the specific items that had the greatest effect on many of our clients.
In previous years, the standard deduction or the amount of itemized deductions (whichever is greater) was added to total personal exemptions and dependent exemptions. This amount was used to reduce a taxpayer’s adjusted gross income and arrive at taxable income. This is the amount used to calculate tax due and is income tax calculation in its simplest of terms! Income limits exist and there are many more moving parts in tax calculation. However, for further explanation of the effects of the new tax law, this is really the key concept you need to keep in mind.
Group #1: A surprise refund!
If your return is the same as last year and you made no changes to withholdings and yet you find yourself with a larger than normal or first-time refund, this is probably the result of the increased standard deduction. If you are a single filer and have not itemized deductions on your return in previous years, then you were most likely taking the standard deduction of $6,350 (in 2017) plus the personal exemption of $4,050 (2017). This gives you a combined income reduction of $10,400. Even though the tax law has taken away the personal exemptions, the increase in standard deduction gives the same individual an income reduction of $12,000. That's a $1,600 increase.Here's an example: in 2017 a single filer who receives a W-2, has no children, and does not itemize has $6500 withheld for federal tax from his paycheck during the year. At the end of the year, the tax due is $5,100 so this individual will get a refund of $1,400 ($6500 - $5100). In 2018, this same individual, with no changes to his filing status, has $5,900 withheld from his paycheck (a result of the withholding changes) and ends up with a balance due of $4,100. This gives him a refund of $1,800 for the year. Not only does he get $400 more from the refund, but he also kept an additional $600 throughout the year as a result of the decreased withholdings ($6500 - $5900).
|Total Tax Liability||$5,100||$4,100|
Group #2: Taxpayers with a smaller than normal refund
This is still a group most people are okay with because it means they didn’t have to write a check on April 15, however we have many clients who had grown accustomed to a sizable refund and were surprised by a decrease on their 2018 return. For some, the drop has been only a few hundred dollars, but others have received refunds for many thousands less. Most commonly with our clients we saw this as a result of the loss of unreimbursed business expenses deduction or write-off. In the past, taxpayers who have received a W-2, but incurred personal expenses in order to do their job (i.e. mileage, car expenses, home office expenses, travel, client meals, office supplies, etc) could write-off many of those expenses against their W-2 income. For many, these write-offs could be substantial - tens of thousands of dollars in some cases. These high write-offs could give a W-2 employee with appropriate withhholdings a refund of, for example, $8,000 because of the significant reduction of taxable income created by the unreimbursed business expenses. With those write-offs gone, an $8,000 refund could be closer to $1,500 this year.
Here’s an example: a sales rep with a total income of $100,000 in 2017 itemized her deductions at an amount of $55,000. This included $50,000 in unreimbursed business, home office, and vehicle expenses. This individual ended up with a taxable income of $45,000 and a tax bill of $12,750. Her withholdings were based on a $100,000 income so total tax withheld from her paycheck during 2017 was $20,000. This resulted in a refund of $7,250 ($20,000 - $12,750). In 2018, however, this person goes from taking an itemized deduction of $55,000 (remember - $50k in unreimbursed business expenses) to taking the standard deduction of $12,000. That is a $43,000 drop in deductions! Her withholdings automatically decreased by about $2,500 (more money in her pocket throughout the year) and her refund dropped to $1,350. That’s a total of $3,850 back ($2,500 + $1,350), but it’s a far cry from the $7,250 refund she had gotten the year before.
|Total Tax Liability||$12,750||$16,150|
Group #3: First time balance due or a larger than normal balance due
Unfortunately, we encountered many people belonging to this group during tax season. Tax payers typically found themselves in Group #3 for 2 reasons: an increase in income (from W-2 or 1099s, retirement accounts, stock sales, etc) and a decrease in withholdings. Many of our clients who found themselves in Group #3 on Tax Day typically had a balance due with their filing in previous years. For most, they were actually paying less total tax for the year even in instances where they had a slight increase in income. It was the decrease in withholdings and, occasionally, the loss of exemptions that really get them in trouble.
Here’s an example: a married couple with one dependent took the personal exemption deduction of $12,150 (4,050 x 3) in 2017 alongside an itemized deduction of $16,500. That’s a total deduction of $28,650. That same couple in 2018 took the standard deduction of $24,000 resulting in a $4,650 drop in deductions without changing anything about their household or deductions. Both individuals receive W-2s and had a combined income of $155,000 and a total tax liability of $24,500. Their withholdings totaled $20,000 and their tax bill on April 15th was $4,500 ($24,500 - $20,000). In 2018, their income increased to $163,000, but their withholdings dropped to $15,000 ($8,000 more in income, but $5,000 less in taxes withheld). Their total tax liability dropped down to $21,000. If their withholdings had stayed at $20,000, even with the $8,000 increase in income, their tax bill would have only been $1,000. Unfortunately, the automatic drop in withholdings gave them a $6,000 tax bill ($21,000 – $15,000).
|Total Tax Liability||$24,5000||$21,000|
Key points to remember:
- The increase in standard deduction resulted in a sizable increase in deductions for tax payers who did not itemize in the past.
- The loss of personal exemptions is less than added benefit of the standard deduction in single or married filing jointly households that do not have dependents. However, households with multiple depends or households that typically itemized a significant amount of deductions on their return likely saw a negative effect from this change.
- Unreimbursed business expenses (which includes mileage and home office expenses) are no longer deductible if you receive a W-2. There are no exceptions.
- Changes to the tax brackets resulted in an overall decrease in tax due for most taxpayers. Even if you had a balance due this year (for the first time or a balance that was larger than normal), you likely paid less tax total for the year.
Quick tips for 2019:
- Don’t find yourself with a surprise tax bill this time next year. Do a withholding check-up and increase your withholdings where necessary. If you are a contractor or are self-employed, talk to your tax professional about making estimated payments. Remember that the IRS adds a penalty if you owe more than $1,000 at tax time even if you are a W-2 employee with withholdings (see our previous blog post on estimated payments for an explanation of our “pay as you earn” system).
- If you received a sizeable refund, consider updating your withholdings to allow yourself to keep more money throughout the year. A refund is better than a balance due but getting thousands of dollars back in April isn’t always for the best. After all, the US government is the only bank that will hold your money all year and not pay you any interest!
- Review which expenses are still deductible under the new tax law and keep good records throughout the year so you can make the most of your deductions.
- If you are a W-2 employee who typically has significant unreimbursed business expenses, consider talking to your employer about becoming a statutory employee. This will allow you to retain the benefits of your W-2 while also bringing back many write-offs you have lost under the new law. Only a few categories of workers qualify for statutory employee status. Learn more about this option on the IRS website.
- Take advantage of retirement benefits offered by your employer or explore options on your own to reduce your taxable income while also saving for the future (401ks, IRAs, HSAs, etc)