Millions of Americans are benefiting from lower federal income tax rates, yet an unusual number of them may be surprised to find they owe taxes when they file their 2018 returns.
To save this from causing you too much financial distress, it helps to know what's coming and how to prepare for it.
Why you might owe money - despite lower taxes
When federal income tax rates were lowered for this year, millions of workers started seeing more money in their weekly paychecks. They may also associate a tax cut with the probability of getting a tax refund next year. Instead though, changes in how paycheck withholding is being handled may result in more Americans owing money next tax season than in past years.
The sources of the problem include both how withholding instructions are given and the new tax laws themselves. Responsibility for providing withholding tables to employers was transferred from the Internal Revenue Service to the Treasury Department when the tax bill passed. In an effort to get those tables out to employers early in the year -- very soon after the new law was passed -- it seems the tables may not have fully accounted for all the complexities of the new law.
The upshot is that the Treasury Department estimates that 21 percent of Americans are being "under-withheld" -- that is, having less money withheld from their paychecks than they will likely owe. This is up from 18 percent who would have been under-withheld under the old system.
If a 3 percent difference in the number of Americans being under-withheld doesn't sound like a big deal, consider that over 150 million tax returns are filed annually. This means that there will be a few million more people owing taxes next April than would have been the case in the past.
What to do if you are on track to owe taxes
Suddenly coming up with a chunk of cash to pay taxes is an unpleasant surprise that can cause financial hardships for people with tight budgets. But you can ease this burden somewhat if you are prepared for it. Here are some things you can do to get ready:
- Check the IRS tax calculator to see if withholding is on track
The IRS offers a withholding calculator to help you see if the amount of taxes that have been withheld from your paycheck is in line with what you are likely to owe. Compare what the calculator says with the amount your paycheck says you are on pace to have withheld in 2018.
- See if you can ramp up withholding
Check with your company's payroll department to see if there is a possibility of increasing your withholding for the remainder of the year. However, it may be too late in the year to make changes or get caught up in a meaningful way.
- Start setting aside some of your paychecks in a savings account
If the tax calculator indicates that you are likely to owe money on your next tax return, you might start putting aside a portion of each paycheck into a savings account in preparation for paying your taxes. Think of this as doing your own withholding, only with the opportunity to earn a little interest on the money until your taxes are due.
- Roll over maturing CDs into shorter-term deposits
If you have any CDs maturing in the near future, roll over at least a portion of them into a new CD that will mature in time for you to pay your taxes next April. This will allow you to earn interest at higher CD rates without leaving the money tied up when you need it.
- Shop for higher rates on money you are setting aside
If you are setting extra money aside in a savings account or opening a new CD, take this opportunity to shop for higher interest rates. Savings and CD rates have been rising lately; so, by shopping, you might get significantly better rates than your current bank is offering.
If you've been enjoying a fatter paycheck since the tax cuts were passed, that's great. Just don't spend it all until you check how much of that extra money you'll be able to keep.