I pay all the taxes owed, and not a penny more” – Mitt Romney
For many taxpayers, the dread of gathering information, preparing a tax return, and filing it is tedious and time consuming. However, just as the sun shines brightest after a rain, cheers and smiles replace the angst of prep when the tax refund check makes its way to the bank account.
“I’m going to … take a trip, buy a TV, go shopping…” After all, a common thought when receiving the refund is “it’s my money AND it is a refund! I should live a little.”
Sure, many have heard they should invest the tax refund money, pay off a credit card or apply the windfall to some other debt. The question is not what to do with the refund, but rather, why are you receiving such a large refund? Is there a better strategy to planning for your tax obligations?
The answer to that question is, “yes!” Simply stated, the goal is to break even on your tax return; owe little-to-no tax each filing season, but try to keep any refunds to a minimum, as well. This means ensuring your withholding from your employer is properly calculated.
When you receive a refund from the IRS – you have essentially given the government an interest-free loan on YOUR money for a year. That refund represents money that was yours all along, but in between earning it and filing your return, the government had your money and used it to their advantage at no charge. You are just now getting it back (and, at no benefit).
Read: Can you deduct your pj's and coffee?
In other words—you deposited that money in the equivalent of a one-year CD at the Bank of the Federal Government, paying zero interest.
Let’s look at an example:
Your friend (also known as the government), asks to borrow $3,100, (which was the average amount of Americans’ 2016 tax refunds). You happily oblige and your term is one year and, because he is your friend, you forgo applying any interest to your generosity. One year from now, your friend will pay you back exactly $3,100.
Easy. In this scenario, your friend is happy he was able to use your money for one year at no cost to him.
Now, let’s say your same friend, again, comes to you and asks for a $3,100 loan, but this time, you’re feeling like a really nice guy, and give him $3,100 with the same one year, no interest terms and, feeling generous, you quietly give him $1,900 more than he asked. He cheerfully takes the money from you and, at the one-year mark, he comes to you with both his original ask of $3,100 and gives you $1,900, the balance of the extra money you gave him. You are excited – he only asked for $3,100, and now he’s giving you back your money. You actually forgot about the $1900 extra because he came to you only asking to borrow $3,100.
In your mind, you have $1900 more. In actuality, you are only getting back what was yours in the first place.
As you can see, when you receive a refund from the IRS on YOUR money, you have allowed the government to keep your money interest free for up to 12 months. So, why does this matter? Well, would you rather have the extra money in your paycheck each month, or provide an interest-free loan to the government for a year, with no benefit to you?
The $258 each month that you didn’t know you could have right now ($3100/12), could make you MORE money if you funnel it to a savings, investment, or pay down a high-interest credit card, (which as you know, is costing you money.)
Let’s also assume that you have outstanding credit card debt at 18% which continues to compound interest… and the government still has your money… you’ve just loaned your money at 0% while your debt accrues interest (averaging 16-22%), putting you deeper into debt.
What to do
Now that you have a better understanding of refunds and payment, let us look at the perfect-world scenario, in which, each April, your tax bill is “$0”. You owe nothing and are due no refund. The reality is that it is not likely to get to zero. However, you can adjust your federal withholding rate by figuring out how many exemptions to claim on your W-4 to ensure your withholding amount more closely approximates your expected tax liability. The first step is to understand your W-4.
What is a W-4?
A refresher - - when you were first hired by your current employer, you filled out a bunch of paperwork, including a form W-4 and its related worksheet. Many people skip the worksheet and simply check “single or married” and pick a number (of allowances), one through nine. Your employer then withholds taxes, based on the number of allowances you claim on your W-4.
Your tax withholding is determined by the figures on your W-4. This system works well in the “perfect world;” that is, if you are a “standard” taxpayer who files single, has one job, and claims a standard deduction. However, most of us do not fit into this category — and, as a result, are likely to have too much or too little tax withheld, creating an under- or overpayment of tax.
How does the imbalance happen? The more exemptions you claim on your W-4, the less money your employer will withhold from your paycheck. So, if your refund seems more like a windfall, it may be time to make an adjustment. Meeting with your tax advisor is always beneficial at this point as well; while one shouldn’t gloat at the huge refund, no one really intends to be socked with (or is readily prepared for) a $3,000 tax bill in April, either.
The Not-So-Perfect World
Now that you know the smart way to manage your tax bill is to adjust your withholding, visit the IRS Withholding Calculator to run some scenarios. The Withholding calculator is a nifty tool that can help you determine how many exemptions you should list on your W-4.
You can adjust your withholding at any time. Ideally, you should adjust your withholding if you have had any of these life-changing events:
- You were unemployed part of the year
- You took a second job
- You got married or divorced
- Your spouse got a job or lost a job
- You had a baby or adopted a child
- Your number of dependents changed
- You bought a house with a mortgage
As you can see, simply filing the W-4 once, when you are hired, is not sufficient if you have had significant life changes. Keep in mind, the later in the year you adjust your withholding, the smaller effect it will have on your current year taxes.
Back to what to do with that meaty tax refund.
While ‘things’ are fun, it’s a great time to stash away your refund for your emergency savings, (six months living expenses to include rent/mortgage, utilities, credit card payments, insurance premiums, auto loan payment). Every person should have an emergency stash tucked away and only to be used in the event of job loss or catastrophic event.
If your emergency savings has already been established, it may be a good time to work on some of your long-term investment or saving goals, too. While it may feel like a letdown to owe tax each spring or put money away from a refund instead of spending, it really will be to your advantage.
Our team of tax professionals is ready to help you or your business properly project and calculate the amount of tax owed based on your situation. Contact us at firstname.lastname@example.org or 216.831.0733 to learn more.