Tax time: It's perhaps the perfect definition of a love-hate relationship.
For most Americans, preparing your taxes is a chore. Working your way back through 12 months of finances, deductions, credits, and income can be laborious, even with do-it-yourself software or a tax professional by your side. To boot, Form 1040, which is the most basic of all Internal Revenue Service (IRS) tax forms, has more than 100 pages of instructions. Preparing your taxes stinks! There, I said it.
On the other hand, the "reward" for preparing your taxes is often great. Historically speaking, about 3 out of every 4 taxpayers will receive a refund from the federal government. Over the past decade, the average refund tends to be around $3,000, give or take a couple hundred dollars. This income is often used to pay down holiday-season debt, to make discretionary purchases, to build up emergency saving accounts, or for investment and/or retirement purposes. You could go so far as to say that a majority of the public has become accustomed to receiving a sizable refund each year... until 2019.
President Trump giving remarks in New Orleans. Image source: Official White House Photo by Tia Dufour.
Average tax refunds have dropped almost $530 from 2018
Last week, the IRS released its weekly report on 2019 filing season statistics for the 2018 calendar year. Through Feb. 15, 2019, the IRS had processed close to 38 million returns and had issued close to 23.5 million refunds. The concern among the public is that the average refund issued this year is $2,640, a 16.7% decline from the $3,169 average refund issued as of Feb. 16, 2018.
With the average refund down considerably -- and so far 27% fewer refunds issued compared with this time last year -- it has people questioning whether President Trump's hallmark legislation, the Tax Cuts and Jobs Act (TCJA), was nothing more than a sham.
As a refresher, the TCJA permanently reduced the peak marginal corporate income tax rate from 35% to 21%, as well as lowered marginal income tax rates for taxpayers. In plain English, it was designed to lower the federal tax liability for a majority of taxpayers through Dec. 31, 2025, which is when the individual portion of the tax changes will sunset. The fact that the average refund has dropped by nearly 17% has some questioning whether these tax cuts simply went to the rich and passed over low- and middle-income families.
While it's far too early to tell the true impact of the TCJA, one thing we can say with certainty is that this decline in tax refunds is not President Trump's fault -- nor is it a bad thing.
Image source: Getty Images.
The real reasons tax refunds are down year over year
Following increased scrutiny as refunds fall, the U.S. Treasury Department defended these lower payouts by pointing out that the year-over-year data isn't of the apples-to-apples type. According to the Treasury Department, there was a considerably higher number of low- and middle-income filers who qualified for the Earned Income Tax Credit (EITC) who filed early in 2018 and received their refund prior to Feb. 16, 2018. This year, there simply haven't been as many early filers with the EITC, straining these year-over-year comparisons.
An even bigger year-over-year difference was pointed out in July 2018 when the Government Accounting Office (GAO) issued a 26-page report on individual and employer responsibilities with regard to tax withholding. The gist of the report was that the U.S. Treasury Department had limited data to work with when modeling tax-withholding guidelines for 2018. These data limitations, combined with the changes to the U.S. tax code by the TCJA, led to employers withholding less income from workers' paychecks. Translation: People are getting more of their money upfront in their paychecks rather than getting it back in one lump-sum come tax time.
Another contributing factor -- and to build on the previous point -- is the fact that most taxpayers didn't understand the scope of the changes introduced by the TCJA. Working Americans have the option of adjusting their tax withholding via Form W-4, but as my colleague Dan Caplinger describes, it's easier said than done. Workers not adjusting their W-4 despite major changes to the U.S. tax code led to more under-withholding and less over-withholding.
To be perfectly clear, this doesn't mean that every single taxpayer will have a lower tax liability in 2018. The removal of personal exemptions, as well as limits on the mortgage interest deduction and state and local tax (SALT) deductions, could certainly mean some folks will see a higher federal tax liability when all is said and done. But to suggest that your tax refund is down because of Trump simply wouldn't be accurate.
Image source: Getty Images.
A smaller refund is actually a good thing
If anything, Trump should be lauded for passing tax reform that leads to more balanced withholding.
As much as you might dislike the idea of receiving a smaller tax refund, or perhaps even owing a bit to the federal government come April, tax refunds are generally not a good thing. Sure, retailers count on consumers to go on a shopping spree once they get their refund checks back from Uncle Sam, but a tax refund is nothing more than an interest-free loan that you've given the federal government for perhaps more than a year. Refunds work great if you're an impulsive shopper who isn't using a budget and has no other means of saving money. But for a majority of the American public, a tax refund is nothing more than physical evidence that you did a poor job of managing your money during the previous year.
For example, there are some folks who believe that netting a big tax refund is perfect for helping to pay down credit card debt in one lump sum. But here's the problem: Credit card interest (or any interest-bearing account, for that matter) is building up all year long while you wait for your large refund. Had you managed your withholding properly, each of your paychecks would have been larger, and you could have worked on reducing the principal debt owed prior to it being affixed with interest.
The same goes for investing. You could wait months, or perhaps more than a year, to invest your tax refund -- or you could put that money to work on a weekly, biweekly, or monthly basis in the form of a higher paycheck. As a reminder, the stock market has historically averaged a 7% annual gain, inclusive of dividend reinvestment and when adjusted for inflation. Waiting on your tax refund could be costing you this 7% each year.
In short, a 17% decline in tax refunds isn't indicative of a sham. Rather, it's an indication of more efficient tax withholding, and the likelihood that a majority of workers are receiving more money each paycheck.
