Earlier this year, the IRS issued IR-2020-09, in which it announced the launch of a new and improved Tax Withholding Estimator. The Tax Withholding Estimator (the “Estimator”) is designed to help employees adjust their federal income tax withholdings by performing a “Paycheck Checkup.” The process also helps employees target the refund they want by adjusting the amount of federal income tax taken out of their pay. The Estimator incorporates changes from the redesigned Form W-4, Employee’s Withholding Certificate that employees can complete and give to their employers this year. To adjust for the amount of refund desired, the Estimator features a customized refund slider that the employee can use to select a refund from a range of amounts available. Based on the refund amount selected, the Estimator will give the employee instructions on how to fill out their Form W-4 or allow the employee to download a pre-filled Form W-4 based on the Estimator’s recommendations.
The new Estimator also features a tool that allows anyone who expects to receive a bonus to indicate whether tax will be withheld. (It is somewhat unclear why tax would not be withheld from a bonus payment, other than employer non-compliance). It retains improvements made last year that allow for the handling of pension income, Social Security benefits, and self-employment tax (see earlier coverage).
Beginning in 2020, income tax withholding is no longer based on an employee’s marital status and withholding allowances. Instead, income tax withholding is generally based on the worker’s expected filing status and standard deduction for the year. Workers may also choose to have itemized deductions, the Child Tax Credit, and other tax benefits reflected in their withholding amounts for the year. The IRS has released a video alerting taxpayers of the new Estimator to which employers may wish to direct their employees’ attention.
Apparent Glitches in the Tax Withholding Estimator
The IRS has done a formidable job developing the Tax Withholding Estimator, but we identified a few issues while we were testing it out. Admittedly, we are nitpicking, and many of the issues would likely affect employees who would use a tax professional to determine how to complete their Form W-4. One issue relates to potential adjustments that are not identified in the data entry fields in the “Adjustments to Income” area of the Estimator. For example, if a user has capital loss carryovers and plans to utilize a $3,000 carryover to offset ordinary income, no field specifically calls for that item. As a workaround, the user can simply enter that amount in another field that is not in use.
Another issue arises for employees who work for employers that pay them in advance. This is not a common practice, but it does happen. For example, an employer may pay its employees at the beginning of a month for the entire month. The Estimator asks the user to enter how frequently the user is paid, the date of the user’s most recent pay period end, the user’s federal income taxes withheld for the year to date, and the user’s federal income taxes withheld from their most recent paycheck. Nevertheless, the Estimator does not allow the user to enter a date for a pay period end that is later than the current date. Thus, if the user was paid on February 1 for the month ending on February 29, the system will overestimate the amount of federal withholding for the year. To address this glitch, the user would need to modify their data entry to reflect their wages for the immediately preceding pay period—in this case January—and enter the previous month-end (January 31 in this example) to prompt the system to correctly calculate their 2020 federal income tax withholding.
One other issue we identified relates to federal withholding on bonuses. The Estimator specifically instructs users to enter bonuses earned or to be earned during the year, and it prompts the user to indicate whether the user’s employer will withhold on a future bonus. The logic of the Estimator assumes that the employer will apply optional flat rate withholding under the Treasury Regulations, which is currently 22%. Admittedly, this is probably a pretty good assumption for most users. However, the Estimator does not consider two potential issues that may arise. First, some employers may not apply optional flat rate withholding, but may simply withhold under the aggregate method (i.e., as if the bonus were paid through a regular payroll). Second, the Estimator makes no adjustment for users who enter bonus amounts over the $1 million threshold that requires mandatory flat rate withholding. Rather, the system continues to assume withholding at 22% rather than adjusting for the mandatory flat rate withholding of 37% as required by the regulations. Accordingly, the Estimator may reflect withholdings well below what compliant employers will withhold from the user’s bonus compensation. We suspect that the IRS developers assumed that high wage earners who receive supplemental wages in excess of $1 million likely have tax advisers and are not using the Estimator.
The IRS has come a long way in developing the Estimator, and it is a useful tool for taxpayers. However, prudent users would be wise to “trust, but verify” when reviewing their results.