Should You Be Happy About A Tax Refund?

With families filing their tax returns in the next few weeks, there is a lot of talk about refunds. The 2017 tax law change adjusted the 2018 tax rates, deductions, and withholdings. Together, these changes mean most families will not be getting the same refund they were used to in the past.

As upsetting as a smaller refund may be, remember your refund does not determine the tax you really owe for the year. To understand why most families receive tax refunds, you need to understand how the United State tax code calculates your tax liability.

Tax rates are assessed on income, whether that income results from earnings, self-employment, or investment returns. But no one pays tax on all their income. Before calculating tax liability, every family can reduce their taxable income with various deductions.

Most families receive a standard deduction of at least $24,000. So, if your combined income is $100,000, you would be responsible for paying tax on $76,000. 2018 liability would be about $8,700. But there are other deductions that could dramatically decrease your taxable income. For example, payments to a mortgage, making gifts to charity, having children, or paying for childcare or college, are just a few examples of expenditures that result in additional deductions.

Whatever your tax liability for the year is, you are responsible for paying it throughout the year. Unless you are self-employed, these payments are automatically taken out of each pay check by your boss and sent directly to the IRS.

Overpayment

Tax refunds simply mean your boss took too much out of each pay check. It’s not their fault though. Your boss doesn’t know how much your mortgage payments are, or how much you give to charity, or even how many kids you have, so there is no way for them to perfectly guess what your real tax liability is going to be for the year. If you don’t know what your deductions are going to be ahead of time, you don’t know what your exact tax liability is going to be.

Therefore, when your boss withholds tax on each paycheck, a guess is made as to the amount of each withholding. When you file your taxes the following April, you determine your real tax liability and reconcile the amount already paid with what you really owe. If you overpaid during the year, you get a refund. If you underpaid during the year, you need to pay the remaining balance.

Think about it, would you rather have $100 a month to spend, or $1,200 the following April. There is no right or wrong answer here. Some look at overpayment of taxes as a method of forced saving. But, financial theory dictates that you should always take your money now, not later. A larger paycheck now is better compared to a refund later, simply because you could invest the greater monthly income now, generating a positive rate of return.

So what do you do if you are anticipating a large refund? You can work with your HR department to dial in your withholdings, minimizing your per pay check withholding. Provide HR with the annual dollar value of how much you want to reduce your withholding by. For example, if you normally receive refunds of $2,000, tell HR you want to reduce withholdings by $2,000 per year, getting you close to a break even for the year. They will help you use IRS form W-4 to calculate the revised withholding amount.

Underpayment

I’ve seen families take reduction of income tax withholdings too far though, so be careful. Pay too little during the year, and you could be faced with paying additional tax in the form of underpayment penalties.

To avoid penalties, you are required to pay at least 90% of what you are going to owe in tax for the year. Let’s say your tax liability is calculated as $10,000, but your withholdings from your paychecks only add up to $8,000. You have only paid 80% of what you owe, so you may owe an underpayment penalty.

The amount of the penalty is calculated for on IRS form 2210. Penalties are assessed on the amount of underpayment below the minimum required. In this example, if your minimum required tax was $9,000 and your withholdings were $8,000, your penalty will be approximately 3.6% of the $1,000 underpayment, or $36.

While underpayment of taxes is rare, it can occur for those who are self-employed and don’t have an HR department withholding tax out of each pay check. Underpayment is also a common occurrence for families who have a lot of investment or rental income.

Avoiding underpayment penalties is straight forward. If you are anticipating that your withholdings will not cover your minimum tax liability, you should be making quarterly payments to the IRS using form 1040-ES. Don’t worry too much about paying exactly the right amount. When in doubt, you should be overpaying your quarterly estimated amounts. Overpayment will simply result in a refund when you file your tax returns the following April.