Tax Liability Versus Your Tax Refund

 In Taxes


  • 2018 tax reform led to tax cuts for most Americans
  • Tax cuts were in the form of slightly higher paychecks, which were hard to notice
  • People who are expecting a large refund check will be disappointed

This month, I’m writing about taxes. Federal tax law changed in 2018 due to the Tax Cuts & Jobs Act. In this post, I’ll discuss the most noticeable impact of the tax reform: smaller tax refunds. In my next post, learn about how the tax changes will impact your 2018 tax return.

Don’t Confuse Tax Refunds with Tax Liability

Pop quiz: if you had to pick between the two scenarios, which would you prefer?

Scenario #1 Scenario #2
Tax refund (or tax owed) $1,000 tax owed $1,000 tax refund
2018 tax liability $25,000 $27,000
Tax withheld from paychecks $24,000 $28,000

Most Americans would avoid scenario #1 because it would be painful to pay $1,000 tax bill. Scenario #2 looks attractive because getting a tax refund feels good. However, the actual tax liability is higher in the second scenario: $27,000 rather than $25,000. Scenario #1 is better because of the lower tax liability.

The average American household’s federal tax cut will be approximately $1,600 according to the Tax Policy Center. But many people who received tax cuts believe the Trump administration raised their taxes.

In 2018, tax cuts were in the form of slightly higher paychecks. But since the increase in paychecks wasn’t very large, people didn’t notice the tax cuts. Even if you took the trouble to examine your paystub, it would have been tough to decipher the tax cut amidst the countless other deductions, like insurance premiums, and 401(k) contributions.

The Mechanics of Paying Taxes

In the US, you must pay income taxes throughout the year. The income taxes are withheld from your paychecks because the IRS doesn’t want to wait until next April 15th for its money. You can adjust federal tax withholding by submitting an IRS Form (the W-4) to your HR department. If your state has income taxes, there is an equivalent form (DE-4 for Californians).

How Did We Get Here?

Bigger paychecks are normally a good thing. But withholding fewer taxes runs the risk that either: (1) your tax refund will be smaller than expected, or (2) you may OWE taxes on April 15th.

After the Tax Cuts & Jobs Act became law in late 2017, the IRS had the daunting task of quickly implementing sweeping changes. This included updating “withholding tables”. The IRS prepares withholding tables as a guide for your payroll provider (e.g., ADP or Paychex) and your employer to withhold federal income taxes from your paychecks.

When you started your job, you completed an IRS form known as the W-4 form. This form helped you tailor your tax withholding to your personal circumstances. The problem after the 2018 tax reform, however, was that employers were combining new withholding tables and outdated W-4 forms to calculate withholding amounts. On January 11, 2018, Treasury Secretary Steven Mnuchin asked hundreds of millions of American workers to use the IRS Withholding Calculator to see whether they needed to adjust their withholdings with a new Form W-4. But the IRS struggled to revise the Form W-4. It also didn’t help that this calculator wasn’t available until February 28, 2018. Payroll services provider ADP released research showing the “vast majority” of people did not change their W-4 elections from 2017 to 2018.

If you don’t pay a minimum amount of taxes by December 31st, you’re subject to late payment penalties. For federal and California income taxes, this minimum is the lower of:

  • 100% of last year’s tax liability (110% if you’re a high earner), or
  • 90% of this year’s tax liability

Why You Should Avoid Tax Refunds

I tell my clients to avoid a large tax refund. This allows them to avoid giving the government an interest-free loan. The goal is for the amount withheld from their paychecks to match their tax liability. In Scenario #1 described above, the goal is to withhold as close to $25,000 as possible from your paychecks, and to have a $0 tax refund. Practically speaking, a tax refund of <$1,000 is close enough.

You then have more cash flow throughout the year because you’re no longer overpaying taxes, which is the situation that leads to tax refunds.

Many Americans don’t think this way. Instead, they view the refund as a means of forced savings. They live on a smaller paycheck, and they wait excitedly for a big refund in the spring. About 75% of Americans receive a tax refund. And by following my approach, the lack of a refund would feel like a letdown.

Have tax questions? Schedule a free consultation.


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