Now that most individuals have filed their 2018 tax returns, they have experienced the changes and major impacts wrought by the Tax Cuts and Jobs Act that was signed into law in late 2017.
Some people were disappointed to learn that their tax refunds were lower this year than they have been in the past. In some instances, people didn’t get refunds at all — instead, they had to pay more when they filed.
Where’s my tax cut?
As a result, some people questioned whether they really benefited from tax reform — “If tax reform supposedly lowered my taxes, why isn’t my tax refund higher?” Or worse, “Why do I have to pay more money in taxes to the IRS?”
What many don’t realize is that the size of their tax refund isn’t indicative of how much federal income tax is actually owed. Comparing these two things is like comparing apples and oranges.
To properly compare tax years, the tax liability – not the tax refund – should be compared.
As an example, say a person’s federal tax liability in 2017 was $10,000, but they paid $12,000 throughout the year. They would have ended up with a $2,000 tax refund at the end of 2017. In 2018, after the tax reform, their federal tax liability may have dropped down to $9,000. After the adjustment, they paid only $9,500 throughout the year, leading to a $500 tax refund.
While it’s easy to compare the decrease in tax refund amounts between the two years, it’s really the difference between tax liabilities ($1,000 lower, in this example) that should be used to get a clear picture of the tax reform.
The tax law changes decreased marginal tax rates across the board, which resulted in a lower overall tax liability for most Americans. To allow people to start enjoying the benefits right away, the IRS adjusted the tax withholding tables used by employers to calculate how much tax to withhold from employees’ paychecks each pay period.
Because the IRS adjusted the tax withholding tables in February, 2018, many people began receiving higher take-home pay for most of the year. In other words, instead of receiving a large refund after they file their taxes, these employees received larger paychecks throughout the year.
Many people may not have noticed (or simply forgot about) this increased take-home pay. These adjustments were automatic without having to make any tax withholding changes through employers.
According to the Tax Policy Center, the average tax cut for all U.S. households was about $1,200 in 2018, or about $100 per month. However, early during this tax-filing season, the size of the average tax refund was down almost 9 percent from a year earlier.
This prompted many people to complain not only that they didn’t benefit from tax reform, but that they were worse off than they were before the legislation. But by early March, the size of the average tax refund had risen to $3,068, which was 0.7 percent higher than a year earlier.
Should you want a big tax refund?
With the increased attention that has been focused on the size of tax refunds this year, now is a good time to point out that getting a large tax refund isn’t necessarily the most prudent thing from a financial perspective.
Why? Because a tax refund represents money that you overpaid to the federal (and possibly state) government throughout the year. In other words, your tax refund is really an interest-free loan that you made to the government.
Consider the average tax refund of $3,068. Instead of receiving this in a lump sum after filing your taxes, you could increase your take-home pay each month by about $255 by adjusting your payroll withholding.
Adjust your withholding now
If you were unpleasantly surprised by the amount of your tax refund this year (or if you owed a relatively large amount), now is the time to make changes to your tax withholding so it more closely resembles your tax liability for this year. This will be easier to do now, since you have a full year of experience under the new tax law.
Talk to your human resources department and tell them that you want to complete a new Federal Form W-4. Adjusting how much money is withheld for federal taxes each pay period will involve claiming either more or fewer dependents (depending on whether you want to increase or decrease your withholding).
Or, you can simply tell your payroll department how much more or less you want withheld in federal taxes each pay period and they can help you determine how many dependents you should claim.
Mark Howe is a Certified Financial Planning professional and member of the Financial Planning Association of Greater Kansas City. He is a Partner & Senior Financial Planner with Frontier Wealth Management.