Do you get a tax refund from Uncle Sam, or do you end up owing money come tax time each year?
Most are very excited to get a large tax refund, but it may not be in your best interest.
While you don’t want to be hit with an unexpected bill at the end of the year, you don’t want a big refund either.
Optimally, you would pay all of your taxes due during the year. That is often difficult to do because your plans can change during the year that affect your deductions and even total income, but the closer to zero you can get, the better.
Some think that’s crazy, after all, isn’t it better to get a big check come tax time? No, not really.
What many don’t realize is that if they receive a refund, they are giving an interest free loan to the IRS.
Do You Pay More in Taxes Than You Owe?
Many believe the tax refund they receive from the IRS is a bonus or gift of sorts. That isn’t the case for most workers. The only way that is the case is if you fall into a category of wager earner that receives back more than they pay in income taxes during the year through various tax credits including the Earned Income Tax Credit (EITC).
However, even if you receive more than you pay in federal income tax, you may want to keep more of that during the year. The next section will tell you how.
It is easy to figure out if which category you fall into.
Look at your tax refund. Now look at your W-2.
If your refund from the IRS is bigger than the number in item 2, break out the sparkling water, you received back more than you paid in federal income tax.
If item 2 (Federal income tax withheld) is more than your refund check, it simply means you paid more taxes during the year than you actually owed.
If you have to pay at the end of the year, it means your employer did not withhold enough to cover your full tax liability during the year.
Tax Withholding, What is it all about?
Withholding are simply taxes that your employer withholds from your paycheck and sends to the IRS that help meet your tax liability throughout the year. Instead of paying it all at once come April 15th, a portion of your paycheck is withheld to cover your estimated tax liability throughout the year.
If you paid more than you owed during the year, you get a refund.
If you paid less than you owed, you have to write an additional check.
The W-4 helps to estimate your tax liability. If your employer has you complete a W-4, they use the information you provide on the form to estimate how much you owe for each pay period. However, if an employer does not have a W-4, they are supposed to estimate your withholding at the highest level based on withholding tables, and assumes single filer status with no exemptions.
Reasons You May Want to Change Your W-4
- You receive a big tax refund. As we mentioned before, if you received a check from the IRS, you effectively gave them an interest free loan during the year. Some people may want more of that money in each paycheck so they can invest, save or spend it throughout the year.
- You have to write a big check. The other side of the spectrum is if not enough is being withheld and you have to write a big (often unplanned) check to the IRS. That can be a big and unwanted surprise that makes it difficult to plan and budget. Changing your form so that more is taken out during the year will help.
- Your filing status has changed. If you get married or divorced, it will affect your actual tax liability. It is a good idea to update your W-4 if these events occur.
- You have a baby. Additional dependents can help to reduce your tax bill, if you want to keep more of that money during the year, make sure to notate that on your W-4.
How to Change Tax Withholding?
You can change the amount that is deducted from your taxes by changing the information on W-4 and having your employer withhold taxes based on that. Generally the fewer allowances you claim, the larger the tax withholding from each paycheck. On the other side, the more allowances you claim, the lower the tax withholding.
Below is a brief summary of tax allowances and how they impact your taxes:
- Claiming Zero Allowances:
- Maximum amount of taxes will be taken out of each paycheck
- Likely will result in a tax refund from Uncle Sam come tax time
- Claiming 1 Allowances:
- Still will likely get a refund come tax time
- Good idea if you are single and have one job
- Claiming 2 Allowances:
- This option will likely get you close to even; where you might get a small tax refund or owe a small amount come tax time
- If you are married, could claim two allowances being one for you and one for your spouse
- You can still claim 2 allowances even if you are single
- Claiming 3 or more Allowances:
- If you are married with a child or multiple children, this option would likely get your close to break even on your tax bill
You can try claiming a different amount of allowances each year to see which gets you closest to break even on your taxes.
Some People Like a Refund and That’s OK
Even with all of this taken into account, there are a lot of people who would rather get a sizable check from the IRS, or at the very least, a small check instead of owing additional money.
For some, over-paying on their income taxes during the year is a bit of a forced savings plan. It is technically best to receive that money during the year so you can invest it, but that requires more financial planning and discipline.
You have to be realistic and honest with yourself on this. Some people are more likely to stash away a $600 refund at the end of the year than they would save the $50 extra a month instead.
If the refund is over $1,000, you may want to consider at least reducing your withholdings a little. The difference between investing $1,200 at the end of the year, or $100 a month may not seem like much, but over the course of your career, with compound interest that can add up to a considerable difference.
What Should You Do With Your Refund?
Just be sure that if you stick with the forced savings plan, you don’t blow your refund. Treat that as ‘found money’, but take our recommendation on what to do with windfalls, gifts and other unexpected money.
- Stash it away toward your rainy day fund (Start with $1,000 – $2,000).
- If your rainy day starter fund is set, pay down debt.
- If both of those are done, pad your rainy day fund with 4-8 months worth of expenses.
- If those 3 are done, invest toward your long term future.
Q: Do you prefer a refund or keep your money during the year? We want to hear from you. Share your thoughts in the comments below!
Certified Public Accountant, Masters of Business Administration, Masters of Science in Accounting, Chartered Global Management Accountant, Family Man