Income taxes: Let’s go back to the very beginning

I’ve been thinking lately about salt. Not SALT—state and local taxes—but salt. The ubiquitous stuff we sprinkle on everything without thinking much about it. Common table salt isn’t just salt with some iodine thrown in. There are five ingredients in table salt, including the salt. Who knew? Whoever thought to look at the label on a container of salt? Well I did, mostly because I’ve had laryngitis, which forced me to buy a new one.

It’s pretty apparent now that employees don’t really understand the ingredients that comprise the income tax system, because they never had to think about it before. Like salt. And that’s where this year’s problems begin.

Time to draw back the curtain

Tax refunds, the size of them or the lack of them, have become a political weapon this winter. Democrats say that the 2018 withholding tables were manipulated to give employees more take-home pay at the expense of their 2018 tax refunds. Republicans are responding that the size of a tax refund only reflects the fact that taxpayers were overwithheld last year. Both are right to some degree.

We don’t know about manipulation for nefarious purposes. Changes made by the Tax Cuts and Jobs Act were included in the 2018 withholding tables and the IRS was very upfront about that. Employees did receive the benefit of the TCJA’s lower rates, wider brackets and revamped tax structure during the year in their paychecks, although it seems that they didn’t notice.

So, perhaps it’s time to reveal the mysteries of income tax withholding and how that relates to tax liability.

Here’s what you need to explain to employees:

The income tax system is primarily pay-as-you-earn. This means that a portion of your income tax liability is withheld with every paycheck you receive. You determine how much we withhold by providing the Payroll department with a Form W-4 on which you indicate your withholding allowances.

The more allowances you claim, the less taxes we will take out and vice versa. Withholding allowances serve as rough substitutes for items that can be credited against your tax liability (thus bringing your taxes down), such as deductions and tax credits. You can see how much is withheld from every paycheck on your pay stub.

The taxes we withhold are credited against your income tax liability for a year. At the end of the year you receive a Form W-2, which lists your taxable income and the income taxes that have been withheld. You then reconcile the taxes that have been withheld from your pay with your ultimate tax liability. You do that on Form 1040:

However, your ultimate tax liability is based on a combination of the taxes you had withheld from your and your spouse’s pay; estimated income tax payments you’ve made during the year; your standard deduction or itemized deductions; unearned income, such as capital gains or dividends; and tax credits, such as the child care credit.

To receive a tax refund next year, you must overpay this year, either through withholding, estimated taxes or a combination of the two. To accomplish that, you will need to adjust the number of withholding allowances you claim and then file a new W-4 with the Payroll department. You can consult the IRS’ withholding calculator or your tax advisor; the Payroll department cannot give you tax advice.

That’s about as simple as we can make it.