Now that April 15 has passed, it is time to focus on the next tax year. Tax laws changed significantly for 2018, and many of the deductions taxpayers were used to claiming on their 2017 income tax returns were not available in 2018. As a result, taxpayers received a smaller refund than average1 and many owed taxes when they traditionally received a refund. Now would be a good time to review and adjust your withholding for 2019 to avoid unwanted tax penalties. Below lists in brief form some of the reasons for the increased taxes and penalties for under-withholding.
Personal Exemption and Standard Deduction
One of the big changes for 2018 is with regard to the personal exemption. Prior to 2018, taxpayers used to enjoy an automatic personal exemption for each member of the household plus either the standard deduction or itemized deductions. Now, there is no personal exemption and instead taxpayers are required to choose between the greater of a higher standard deduction, or itemized deductions. The standard deduction for individuals in 2018 is $12,000 and for married couples filing jointly is $24,000.2 This is the amount to be taken for each filing type, regardless of whether you have dependents claimed on your return.
State Taxes Itemized Deduction
One of the possible itemized deductions is state taxes paid to California, or other states. The average state and local tax deduction for Californians who itemized in 2015 was over $18,400, according to the state Department of Finance.3 Beginning in 2018, your deduction for all state taxes and property taxes paid will be limited to a maximum $10,000, regardless of whether you are a single filer or a married couple. Therefore, in comparing the option of a standard deduction of $12,000/$24,000 to your itemized deductions, many taxpayers who previously itemized their deductions will now be better served to take the standard deduction.
This is particularly true for married couples who will have a harder time overcoming the additional $14,000 in deductions needed to itemize ($24,000 standard deduction less $10,000 in taxes paid) than single filers who only need an additional $2,000 to itemize ($12,000 standard deduction less $10,000 in taxes paid). This means that married couples need to have over $14,000 in any combination of other itemized deductions (such as mortgage interest or charitable deductions) to itemize their deductions. As a result, many taxpayers who donate to charity will not receive any tax benefit from their charitable donations.
For high wage earners and property owners, this new limitation comes at a significant cost. For example, an individual earning around $137,000 in California owes close to $10,000 in state taxes. A married couple owes $10,000 in tax around $175,000 in combined income. If these taxpayers also pay property taxes, they will be limited to deducting a combined $10,000 in state and property taxes; the amount was unlimited prior to 2018.
Both the IRS and California ask that taxpayers pay the tax owed ratably over the year as you earn your income. For most taxpayers, this is done through withholding by their employer. If you do not pay your tax ratably while you earn taxable income, you could face penalties when your return is due. The federal penalty on underpayment has historically been about 3-4% for the past several years. For California, there are harsher penalties and the FTB reports: “The penalty is 5 percent of the unpaid tax plus 1/2 of 1 percent for each month or part of a month that the tax remains unpaid not to exceed 40 months.”4
There are certain “safe harbors” and ways to avoid tax penalties for underpayment. The IRS released two Notices this year to relax the requirements to qualify for the safe harbors. Traditionally, the first of these safe harbors to avoid underpayment penalties is if you owe $1,000 or less in taxes with your tax return. Secondly, you can avoid the penalties if you have paid the lesser of a) 90% of the current year’s tax due, or b) 100% of your prior year tax due.5 So as long as you are withholding at least as much tax as you owed last year, you should be able to avoid any penalties on underpayment, though you may still have a large check to write on April 15.
However, for tax year 2018 only, the IRS first reduced the requirement of paying 90% of the current year taxes owed to 85% in Notice 2019-11, released on January 16, 2019. This was issued in response to the concern that many taxpayers may not have been able to adjust their withholding timely for 2018. Subsequently, on March 22, 2019, the IRS issued Notice 2019-25 which further reduced the 85% requirement to only 80% before taxpayers are subject to penalty. These reductions are in place only for tax year 2018 and may not be available to you next year.
How to Calculate Your Withholding
The IRS has created a Withholding Calculator which is available on their website at IRS.gov. Please note that the calculator may not be accurate for all taxpayers. You can use this to estimate your 2019 taxes due, and then file a new Form W-4 with your employer in the event you wish to change your withholding. You also could make estimated payments on your own if you choose not to have additional tax withheld from your paycheck.
While 2018 may be an unusual year for taxes, the changes instituted by the Tax Cuts and Jobs Act are here to stay. If you found that you owed money in 2018, or had a smaller refund, you may want to consider adjusting your withholding for 2019 to avoid penalties on underpayment of taxes.