So the IRS has released a draft of the W-4 for 2020 (PDF), which indicates withholding is undergoing a fundamental shift. Most notably, the concept of allowances is removed, no doubt due to the fact that personal exemptions no longer exist (the Tax Cuts and Jobs Act which became applicable for 2018 onward got rid of them). A FAQ goes over some of the reasoning and addresses key issues.
My quick-look thoughts are this:
The old way
(skip this if you already know the existing system or don’t care!)
For those that don’t know how the old system worked, it was based on the concept of allowances. Each allowance corresponded to the value of a personal exemption. So for 2017, this was worth $4,050. So say you’re a single person and not a dependent. You’d get to subtract $4,050 from your income right off the bat. If you were a couple with two kids, 4×$4,050. Note you still got the standard deduction ($6,350 for single) as well.
So say you’re single with no kids, or other income or deductions. The IRS would estimate your annual income (paycheck × pay_periods), subtract a small fixed amount to account for the standard deduction as it was larger than the personal allowance ($6,350-$4,050=$2,300), and then would subtract $4,050×(allowances), so 2 allowances was the proper figure (so for a $1,000 weekly paycheck the IRS figures taxable income will be $52,000-$2,300-2×$4,050) The IRS would guide you through this (enter “1” for yourself… enter “1” if not a dependent).
But then the entire concept of personal exemptions went away for 2018. But to keep people happy, Congress nearly doubled the standard deduction (now $12,200 for single) and to handle kids (which were always in addition to the standard deduction), doubled the Child Tax Credit to $2,000. Note this $1,000 credit increase is worth about the same as a $4,050 deduction if you’re in the (large and wide) 25% (now 22%) bracket.
OK, so now there’s no more personal exemptions. But people know what allowances are, so the IRS chose to keep things simple – not to mention the Tax Cuts and Jobs Act was passed into law December 22nd 2017, giving the IRS four business days to enact the largest tax reform in 30 years, so it wasn’t exactly a good time to overhaul the withholding system.
The new way
No more clunky conversions to allowances
So what goes on now is essentially a more direct calculation of what was going on before: the IRS will use your paycheck to estimate your income (paycheck × pay_periods) and now they ask for additional income.
Like before, they ask for deductions you expect, but now we’re free from dividing by the “allowance number” ($4,200 for 2019). So if you expect say, $5,000 in deductions, you put down $5,000. Before you would figure $5,000/$4,200, drop a fraction (better to withhold too much) and put down 1 more, so withholding was really based on you getting a $4,200 deduction.
Also like before, the Child Tax Credit, being so widely used, is handled explicitly. Unlike before, new figures are nice and easy: $2,000 per child. The 2019 system is downright amusing: it asks you to pick 4, or 2, or 1 allowances for each child, depending on your income. This is because if you’re lower income (12% marginal bracket), you put 4 because a 4×$4,200 deduction is worth 4×$4,200×12% = $2,016, so close enough to $2,000. Same logic for 2×$4,200×22% and 1×$4,200×35%.
Emphasis on the IRS withholding calculator
The IRS withholding calculator is mentioned twice in the line instructions and twice in the instructions. The W-4, like before, does not account for any YTD withholding, changes in income, or partial year jobs. So the IRS suggests their calculator, which does do this. It’s accurate, and as you’ll see next, good for privacy…
Privacy. Or: I don’t want my boss to know I have multiple jobs and/or a huge investment account
The W-4 has always operated in a bit of a mystery mode: you put in allowances, and if those allowances need to go down (say you expect $4,000 in investment income – you would need to drop an allowance) it’s been okay because you only needed to hand in the top portion. If you put in 1 allowance vs 2, your employer wouldn’t know why.
The new form though, asks for additional income, and also has spots for indicating multiple jobs. What if you want to hide this? There IRS addresses the privacy issue in the FAQ and tells us there are three main options:
- Use the IRS withholding calculator. It spits out a number to put on 4c (additional withholding), and your employer doesn’t know why.
- Use a Worksheet (1) provided, that you keep for your own records (and don’t turn in)
- Check a two jobs box that basically splits the standard deduction and apply tax brackets among two jobs. This is similar to the “Married but withhold at the higher single rate” on the current W-4 and basically tells your employer to withhold as if you’re single, which works if your jobs have similar incomes (since tax brackets and std deduction are just double for joint filers up to pretty high incomes). Note this option reveals to your employer you’ve got two jobs in the household.
So that’s it for now – the IRS has a few more steps to complete before we can figure out the finer details:
- Provide instructions for employers
- Update the withholding calculator
- Update the $XX,XXX values in the tables
Until then, the IRS is taking comments. I think this is a pretty great change, and more closely aligns with what withholding should be.