Why millions of people are getting hit with a surprise tax bill this year
An effort to make the tax bill look better ended up making it look worse.
Americans who are accustomed to receiving an income tax refund tend to file their taxes early — often in late January or early February when all the paperwork becomes available — but this year many early filers are finding to their surprise that they actually owe money to the IRS.
The new tax law does result in some people paying higher taxes (especially over the long term), but the specific issue here is tax refunds rather than total taxes paid. Whether you get a refund or owe extra to the IRS at filing time is a function not just of your total taxes owed, but also of how much tax is withheld from your paycheck by your employer on paydays. And the big story here is that as a result of the new tax law, the Treasury Department tweaked things so that on average taxpayers’ withholdings fell by more than their actual taxes owed.
This was all explained in a Government Accountability Office report last summer, but it turns out that many people are not regular readers of GAO reports and did not take the GAO’s official advice to check their withholding status. The result? Surprise tax bills!
Tax withholding, explained
Income and payroll taxes are, in a theoretical sense, collected once a year in mid-April.
In practice, however, the government has employers calculate how much tax their workers are likely to owe at the end of the year. Then each pay period, companies simply forward an appropriate amount of money directly to the IRS and pay you what’s left over. When you file your taxes at the beginning of the year, you compare the amount of taxes you owe to the amount of taxes you’ve already paid and get either a refund or a request to send more money. And historically, by design, most people — around 75 percent — get a refund.
That’s because
it’s a lot easier for the government to pay out refunds to people who overwithheld than to run around trying to collect cash from people who underwithheld.
What’s more, when underwithholding does happen, it’s usually either because of an error or else a special situation like a person with a full-time job who also happened upon an unexpected bounty of freelance side-gigs. In fact the government hates underwithholding so much that if you primarily derive your income from freelance or self-employment work, they start charging you a financial penalty unless you pre-pay your taxes on a quarterly basis.
This system was, in a fun historical irony, devised in part by Milton Friedman, the famous libertarian economist, who at the time was trying to help win World War II but who wound up being an unsung hero of the post-war welfare state. And the whole thing had been chugging along pretty peacefully until then-House Speaker Paul Ryan, Treasury Secretary Steve Mnuchin, and Trump decided to shake things up.
How the tax law changed withholding
The 2017 Tax Cuts and Jobs Act
was largely focused on reducing taxes for rich business owners. People who are stand to inherit multi-million dollar estates got an enormous tax cut, as did people who own “small” businesses that generate millions of dollars in annual profits. And, of course, there was a big cut in the corporate income tax rate, with benefits largely flowing through to stock owners in a country where 80 percent of the value of the stock market is owned by the richest 10 percent of the population.
But there were changes for middle-class workers, too.
Most famously, TCJA either eliminated or curbed a whole bunch of popular tax deductions (including the home mortgage interest deduction and the state and local tax deduction) while also repealing a previously implemented phase-out of itemized deductions.
Consequently, the value of most people’s tax deductions went down but some people got to deduct more. Then to compensate for these lost tax deductions, the Child Tax Credit got more generous and was also given to richer people and the standard deduction got much bigger. Individual tax rates, in turn, went down.
In the aggregate, this means higher taxes for a few people but lower taxes for the vast majority of Americans. It also means that virtually everyone’s tax situation is a little bit different from before, often in complicated ways related to the ins and outs of lost and gained deductions and credits. So everyone’s withholdings had to be calculated anew.
The bill was also extremely unpopular. But Republicans spent December 2017 assuring themselves that would change in February 2018 when the new withholdings began.
“On January 1, Americans are going to wake up with a new tax code,” Ryan said
. “On February 1, they are going to see withholdings go down, so they are going to see bigger paychecks.”
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Originally Posted by kona
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