“Our new Constitution is now established, and has an appearance that promises permanency; but in this world nothing can be said to be certain, except death and taxes.”
–Benjamin Franklin (in a letter dated 1789)
I came across yet another news article focusing on the despair that people are having at receiving lower tax refunds, or in some cases paying taxes, this year compared to last. It seems like every one of these articles has the underlying goal of vilifying the Tax Cuts and Jobs Act (H.R.1, 115th Congress, 2017-2018). While I’m not an expert in financial planning or tax law, I tend to be pretty handy with a calculator and spreadsheets. So, with that in mind, I would like to take a stab at laying out my views on these tax changes (Indirectly I want say that everyone just need to grow up, take control of their life, and, most importantly, move on).
Again, I want to stress that I am not an expert in financial planning or tax law, and if you are here for guidance or advice then I advise you to stop reading. What follows is wholly my opinion with a lot of simplification involved to make a point. Let’s start with a simple example that we will use throughout.
Joe Smith works a full time job (40 hours per week) at $20.00 per hour starting at the beginning of 2018. He is going to work every week in 2018 (no unpaid time off, he must be a fortune teller) and has no outside investments. Basically, all we are going to use is his wages for this example. From this information we can make some projections for 2018. Joe is going to make $41,600.00 in 2018 before taxes and benefits (we’re going to ignore these for the sake of simplicity). With a standard deduction in 2018 of $12,000, Joe’s maximum taxable income is going to be $29,600. According to the 2018 tax table from the IRS, Joe’s maximum tax will be $3,365.00.
Let’s stop here for a minute. Why did I only use his wage rate and straight time worked while ignoring paycheck or itemized deductions? Well, all of those factors would only result in lowering his taxable income and owed tax, making my next assumption just that more conservative. The first gripe I would like to tackle is being caught off guard and owing taxes when filing. If you use the very simple information above we can calculate the amount of withholdings necessary to be even (not owing or being owed) on our taxes. We take the maximum tax from above and divide it by the number of paychecks (let’s say Joe is paid every 2 weeks resulting in 26 paycheck in 2018), to find out the minimum amount of withholdings we should see on his paycheck. For Joe this amount is $129.42. If Joe finds that his tax withholdings are lower than this amount each paycheck, then either he needs to plan on owing taxes when he files, or correct his W-4 to increase his withholdings. If the amount withheld is higher than this amount, then either he can enjoy a tax refund when he files, or, again, correct his W-4. It’s that easy. No surprises!
Now, here comes the big problem people seem to be having. Smaller Refunds! Oh my God! That must mean the tax reform raised my taxes. At least that is what the opposition wants you to think. Smaller refunds mean higher taxes. Well, I’m sorry folks, but that is not how it works. As a matter of fact, I would hope that the withholding discussion above shed a little light on how refunds or shortages in your taxes occur. It’s based on your W-4 not the tax rate. In order to see just how the tax reform affected Joe, we need some more information.
In 2017 and 2018 Joe filed the following information on his tax returns.
| 2017 | 2018 | |
| Gross Income | $41,600 | $41,600 |
| Standard Deduction | $6,350 | $12,000 |
| Taxable Income | $35,250 | $29,600 |
| Taxes Owed (table) | $4,825 | $3,365 |
| Effective Tax Rate | 11.60% | 8.09% |
Some things I want to point out. Unfortunately, Joe did not get a raise from 2017 to 2018, but that means his income is flat for our example. The first difference is the change in the standard deduction and the resulting taxable income. 2018 is significantly lower than 2017 due to the large increase in the standard deduction. The second, and most important, difference was his taxes owed. Even though Joe made the same amount in 2017 and 2018, his 2018 taxes were lower thanks to the tax reform passed. His effective tax rate dropped from 11.60% to 8.09% (a 3.51% drop). But how does this correlate to his tax refund. Well, that happens to be the most complicated part of this whole discussion, and the one that I’m far from able to tell you about exactly. But, I can make some educated guesses and clear assumptions to demonstrate how even with less tax owed one’s refund can be smaller.
The way in which employers (or their payroll companies) calculate your withholdings is so complicated with compounding variables, that computers now calculate it out each paycheck. So, I’m going to make some assumptions. 1) The company uses our maximum possible tax amount calculations we made above, and 2) the company adds 15% of that maximum to the actual withholdings as part of their calculations. With those assumptions here is the breakdown for Joe.
| 2017 | 2018 | |
| Maximum Tax + 15% | $213.41 | $148.84 |
| Paycheck Take Home | $1,386.59 | $1,451.16 |
| Annual Withholding | $5,548.75 | $3,869.75 |
| Annual Take Home | $36,051.25 | $37,730.25 |
| Tax Owed | $4,825 | $3,365 |
| Tax Refund | $723.75 | $504.75 |
| In Pocket | $36,775 | $38,235 |
This one is pretty plain. Joe received a bigger refund in 2017, but his per paycheck take home amount was less. Also, when we add his refund to the annual take home amount, Joe had more disposable income in 2018 than 2017, again thanks to the tax reform. So, there you have it. Joe owed less tax in 2018, had more disposable income from 2018 once his tax refund was issued, and yet, his 2017 refund was larger. I guess these reporters and the oppositional pressures just don’t want to look at the details involved.
Now, I know you’re going to tell me that I’ve made a lot of assumptions and over simplified this to make my point. Maybe I did, but I have a real world example to give you here at the end. Here is a generalized view of my tax returns for 2017 and 2018 (spoiler, it’s all going to be percentages with no information for you to take and use against me). I’m going to clarify that the items I deduct (I use an itemized deduction) did not change from 2017 to 2018, though how they effected my taxes did with the reform.
My gross income increased 10.80% in 2018 while my tax amount only increased 5.20%. My effective tax rate was 6.79% in 2017 and 6.44% in 2018 (a drop of -0.34%; this basically means less effective tax owed). My refund dropped 66.80% in 2018 compared to 2017 (that means a smaller refund by more than half). And finally, my disposable income increased 11.21% in 2018 from 2017. What conclusions can I make from this information? I made more money in 2018 but paid less effective tax on that money compared to 2017. That translated into an extra 0.41% added to my disposable income on top of my wage increase. Basically, the tax reform in essence put more money in my pocket on top of my increased wages I received. It may not seem like a lot, but every little bit helps.