Do you have a withholding mismatch?

Individuals 04.05.2019 5 MIN READ

Very few taxpayers withhold the exact amount to cover their tax liability come filing time. Most end up with a refund (withheld too much) but some will owe additional taxes (withheld too little). But what causes this to happen? And how can you better match your withholding to your tax liability?

Federal withholding rules

The IRS requires that you pay a certain amount of your tax liability throughout the year, or they collect interest on what you should have paid them.¹

To add to the complexity, the IRS wants its payments at least quarterly throughout the year (around April 15, June 15, September 15 and January 15 of the following year). That’s no problem for regularly paid wages based on your Form W-4, but can sometimes be more challenging if you have supplemental income such as bonuses, stock awards, stock option exercises and other long-term performance awards, as they are subject to different withholding rules.

For taxpayers with supplemental pay and/or significant income not subject to withholding, they may choose to complement their withholding with quarterly “estimated tax” payments to make sure they don’t fall behind in their tax obligation.

A note on supplemental wage withholding

Supplemental wages are bonuses, commissions, stock options exercises, restricted stock vesting and the delivery of restricted stock unit awards. They represent non-periodic items typically withheld through a special “supplemental wage” withholding flat tax rate method.

Warning—the flat rate used up to $1,000,000 of such earnings is 22%. That would be $220,000 of federal tax withheld. But tax on that $1,000,000 (for illustration, assuming it was the taxpayer’s only income and would be fully taxable income) for someone married filing jointly would be $308,150, creating a shortfall of $88,150.

Understanding taxable income and how to evaluate your withholding

Several variables create a withholding mismatch—none more prevalent than the changes to the tax code under the 2017 Tax Cuts and Jobs Act. Generally, updated withholding tables for 2018 caused withholding to decrease, even if you maintained the same W-4 election.

What drives your refund or balance due comes down to two factors:

Your taxable income and thus your liability, and
Your projected withholding plus other estimated tax payments.

Simple as that: what you owe and what you have paid.

How well do you understand your taxable income?

Your “taxable income” is the primary driver of your tax liability and is impacted by not only your income (e.g., wages, interest, dividends, pensions, self-employment income, etc.), but also by deductions and credits. With the adjusted tax code for 2018, one or more of the following changes likely impacts you:

Items that could cause your taxable income to go up:

Personal exemptions were eliminated
Certain itemized deductions became subject to more stringent limitations:
- State and local (income or sales, and property) taxes—can only be deducted up to $10,000
- Mortgage interest deduction—based on a reduced loan balance threshold of $750,000 (applies to new mortgages, which are generally those obtained after December 15, 2017)
Miscellaneous itemized deductions subject to a 2% AGI limitation (e.g., job-related and investment expenses)—were eliminated

Items that could cause your taxable income to go down:

Standard deduction—amount doubled. For singles from $6,350 to $12,000, married filing jointly from $12,700 to $24,000
Child tax credit—amount doubled and higher income thresholds put in place before they are phased out
Alternative Minimum Tax—increased exemption amounts and raised limits related to those amounts, causing the calculated tax to potentially decline or be eliminated
Overall AGI limitation reducing most common itemized deductions—was eliminated
Marginal tax rates declined. Generally each rate moved down about two to three percent

How well have you evaluated your withholding?

If you end up either over- or under-withheld, there are different ways you can better evaluate your withholding in the future. Knowing how the tax rules affect you will inform your allocation to the IRS throughout the year.

When choosing your withholding for the next year on your W-4, let this year’s return guide you. The W-4 attempts to walk through various aspects of your personal tax situation with provided worksheets. If you use the IRS withholding calculator (at IRS.gov), you might find it easier than filling out worksheets. Both methods attempt to provide you the filing status and number of allowances you should claim in order to be close to your estimated tax liability. If your primary income is from a regular salary, estimating a withholding close to your liability is generally not difficult.

The worksheet and calculator, however, are only estimates and may miss information that could impact your recommended withholding. And, as previously mentioned, additional tax payments may be appropriate for your circumstances. Finally, remember that life events can change your tax situation from year to year.

In conclusion

The tax code gets difficult rather quickly for many, especially as your compensation and personal situation gain complexity. If you don’t feel comfortable navigating your own taxes, you should seek professional tax help to prepare this year’s return and plan accordingly to avoid a mismatch next year.

Tax Preparation: Resources for getting organized and filing your taxes

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¹The safe harbor rules regarding tax payments are this—you must pay the IRS the lesser of:

90% of the current year’s tax liability (which you need to project) [this is 80% just for 2018], or
100% of the prior year’s tax liability (110% for those files with Adjusted Gross Incomes (AGIs) in the prior year over $150,000, or $75,000 for those Married, Filing Separately)

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