Many wage earners were stymied last April when they completed their tax filings. Despite the much-touted anticipated tax savings, which should have resulted in a sizable refund, many taxpayers discovered they actually owed taxes. The reason for this was a shortfall in how much taxes they contributed throughout the year in the form of income tax deductions from their paychecks.
In early 2018, the US Treasury responded to the significant changes enacted by the Tax Cuts and Jobs Act with changes to the Federal Tax Withholding Rules. When the income tax withholding rules changed, many wage earners, who did not adjust the amount of tax being withheld from their paychecks by resubmitting Form W-4s to their employers, found when they filed their 2018 taxes that not enough tax had been withheld throughout the year. This was because the change in tax law modified many of the factors wage withholding was previously calculated upon.
While a taxpayer’s annual tax return is based on their actual circumstances, wage withholding is calculated by a taxpayer’s employer based on the employee’s Form W-4. This form provides a set of information to an employer that mandates an employer to withhold taxes based on certain limited information. The withholding calculation roughly consists of extrapolating the employee’s annual income and subtracting certain amounts based on the information provided as not subject to income tax. The employer withholds an amount equal to a projected tax liability for the amount of taxable income at the filing status (Single, Married, Married But Withhold At The Higher Single Rate, etc.) indicted by the employee on the W-4. Since the W-4 is only an information form provided to the employer, it does not necessarily mirror the taxpayer’s actual tax scenario. Form W-4 is not as extensive as an actual tax filing and as such must often be completed in a manner different from the employee’s actual filing status to ensure the employee is paying the correct amount of income tax. This is particularly common in the case of married taxpayers, where both spouses earn income.
Prior to the recent changes, the Form W-4 prompted a wage earner to mirror their anticipated tax return, providing the wage earner’s filing status and personal exemptions. However, the Tax Cuts and Jobs Act, among other changes, removed personal exemptions, significantly changed the standard deductions for each filing status, reduced itemized deductions, and adjusted tax rates and brackets. As a result, the US Treasury responded by changing the rules on how employers withheld taxes from wages. While the withholding rules for employers changed, the basic format of the Form W-4 did not. As such, new employees could continue to specify filing status and personal exemptions potentially no longer applicable to their tax scenario. Wage earners unaware of the impact of the Tax Cuts and Jobs Act did not revise their Form W-4. While the media coverage surrounding the Tax Cuts and Jobs Act focused almost exclusively on the changes in the tax law, there was almost no coverage of the change in withholding rules, or the need for taxpayers to review and change how they completed their Form W-4s.
The largest change to how Form W-4 should be completed to ensure the correct amount of employer tax withholding involved dependency exemptions. Each withholding allowance indicated represents approximately $4,200 in wages an employer would not consider in its wage withholding calculations. Prior to the recent changes, the number of allowances indicated on a W-4 represented the personal exemptions on the wage earner’s tax return. There was also a more complicated method for using allowances to represent increments by which the wage earner’s itemized deductions exceeded their standard deduction. More often than not, the number of allowances entered by an employee represented the actual number of dependents on their tax return. The Tax Cuts and Jobs Act eliminated personal exemptions, including those for dependents. The US Treasury changed the withholding rules to reflect this change, requiring employers to treat allowances listed on Form W-4 as increments by which the wage earner’s itemized deductions exceed their standard deduction. This was rarely what wage earners originally intended. Coupled with the reduced number of itemized deductions many taxpayers were now entitled to on their actual tax filings, wage earners whose Form W-4 included allowances often had too little income tax withheld by their employer.
Dual income couples have always had difficulty in properly completing a Form W-4 to have their employer withhold sufficient taxes from their wages. Completing a Form W-4 as “Married” informs an employer to withhold at the lower tax brackets that apply to married couples filing joint tax returns, and to exempt the larger married filing joint standard deduction from withholding. When there is only one wage-earning spouse, this isn’t an issue; however, in dual income households, problems can occur. Neither spouse’s employer is aware of the other spouse’s earnings. As such, both employers exempt an amount equal to the married filing joint standard deduction from withholding tax. This is effectively twice the amount that will actually be allowed on the couple’s tax filing. Because each spouse’s respective employer is completely unaware the other spouse is working or what their salary is, that employer only withholds income tax at the lower tax rates that would apply if their employee was the sole household wage earner. This issue was amplified by one of the recent changes in tax law, which increased the married filing joint standard deduction from approximately $12,000 to $24,000.
Fortunately, one of the changes wrought by the Tax Cuts and Jobs Act also assisted in one of the tactics available to minimize the problems of withholding for dual income couples. The standard method for dual income couples historically, has been for each spouse to complete their respective Form W-4s as “Single,” or “Married But Withhold At The Higher Single Rate.” This allowed their employer to withhold taxes as though the employee was only entitled to the standard deduction for single individuals, half the married amount, and based on the single tax brackets. This wasn’t always a complete fix. Prior to the law change, what is commonly called the “Marriage Penalty” – the point at which married filing joint tax brackets are no longer double the amount for the single tax brackets, and dual income couples are taxed proportionately higher than if they had remained unmarried – kicked in at a much lower income level. In 2017, under the old regime, the Marriage Penalty kicked in at approximately $150,000 of combined taxable income. In 2018, under the new regime, it kicked in at roughly $600,000 of combined taxable income. This allowed many more couples to employ the technique without complications.
Ideally, unless advised otherwise by a tax professional, dual income couples should complete their respective Form W-4 as “Single,” or “Married but Withhold at the Higher Single Rate”. Couples where only one spouse earns wages may continue to use the “Married” status. All wage earners should assume 0 allowances. Under current tax law, this is only used for determining income exempt from tax due to itemized deductions and can easily set a taxpayer up for a mistake.
The safest way for married couples to ensure they have sufficient income tax withholding from their paychecks is to resubmit their respective Form W-4s to their employers. After both spouses receive their first full tax period paycheck, dual income couples should engage a qualified tax professional to complete a tax projection. Based on this projection, adjustments may be determined to withholding allowances or additional withholding to resubmit on Form W-4. This is particularly relevant for anyone with additional sources of income, itemized deductions, head of household filing status, dependent or college credits, couples subject to the Marriage Penalty, taxpayers subject to the Alternative Minimum Tax, or just about anything other than wage income and a standard deduction. Completing a tax projection with a qualified tax professional allows a wage earner with a more complex tax scenario, or merely a change in situation, to more closely match their wage withholding with their actual tax liability.
If you would like to discuss projecting your tax liability and adjusting your withholding to more closely match, please feel free to contact us.
Written by Damien Falato, CPA, MST, CGMA, Tax Director
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