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It's tax filing season and that means the ads have started for businesses wanting people to spend their tax refunds buying something they probably don't need or weren't planning on buying. These ads make tax refunds sound like they are free or found money. And many people view their tax refund in the same light. Lots of people get their taxes filed as quickly as they can so they can hurry up and see how much their refund is for and how quickly they can get it.
The truth is, it's called your tax refund because it is exactly that, a refund. It's a refund of your money that you have basically lent the government, interest free, until you let the government know how much of that money is yours and not theirs. And then they will send it back to you, on their schedule. You would be hard pressed to find a bank that would lend you money for a year, interest free, but that is exactly what a large portion of the population is doing: they are lending the government their money interest fee.
If you have a job that withholds taxes from your paycheck you are more likely to be someone that gets a refund. If you are self-employed and pay estimated taxes you may actually owe taxes each year and not get a refund, depending on the accuracy of your estimated payments.
When you begin a job you fill out form W4 with your employer and that information instructs your employer how much tax to withhold from your check. Your employer then remits that money to the IRS (and your state) on your behalf. Then, at the end of the year you receive your W2 and it tells you how much tax was withheld and remitted on your behalf for that year. The accuracy of your W4 will drive the accuracy of the tax withheld. If you have been at a job for awhile or had a major change in your circumstances, you may need to do an updated W4. In the past, people would claim allowances on their W4 to reduce the amount of tax withheld from each paycheck but in 2020 a new W4 form was introduced that changed that.
The new form allows you to adjust your withholding to take out more or less depending on such things as your number of dependents, other jobs you may have, or itemized deductions you may be eligible for. Getting that W4 as accurate as possible will get your withholding most in line with what your actual tax liability is. The goal is to have enough withheld that you don't owe tax that could also be subjected to penalties and interest but also not to have a large overage withheld that results in a big refund. I generally like to think of a refund in excess of $500 as big enough to justify making changes on your W4 for going forward.
If you are self employed then you don't have taxes withheld and remitted on your behalf but you do have to pay estimated taxes throughout the year. These estimates can change as your income changes. The general rule of thumb with estimated taxes is to make the safe harbor payment amount which is 100% or 110% (depending on how much income you make) of your prior year's tax. Then, if your income is growing in the current year you can increase your estimates so that you don't have a big tax bill at the end of the year. We will talk further about taxes for the self employed in another episode. Now, back to the refunds.
As you may recall from the episode about standard and itemized deductions, your tax liability is calculated from your taxable income and that is your total income less either the standard or itemized deduction. From that taxable income figure at the bottom of page 1 of your 1040, you move on to the Taxes and Credits section of your 1040 to calculate your tax due. Your rate depends on the amount of income you make. If you are eligible for credits like the Child Tax Credit, you would deduct that from the calculated tax due to find your net total tax due.
The next section of form 1040, called the Payments section, is where withholdings (as well as estimated taxes paid) are listed. These are the amounts that you have already paid towards that net total tax due. If your withholdings are more than the total tax due then you have a refund, if they are less then you owe the difference.
The Payments section is also where refundable credits are claimed. Non-refundable credits are claimed in the Taxes and Credits section. The credits can be confusing. The first thing to know about credits is that they reduce the actual tax due. Remember the deductions only reduce your taxable income. The second thing to know about credits is that some are refundable and some are not. The non-refundable credits are listed in the Taxes and Credits section because they can only reduce your net total tax due to $0. Even if subtracting the credit from your calculated tax due results in a number lower than $0, you stop there and simply have $0 net total tax due. You don't get a refund for that excess. However, the credits listed in the Payments section are what are called refundable credits. These credits can decrease your tax liability below $0 and that excess is refunded. Some argue that these refundable credits are found money but again if the W4 was tweaked to be more accurate then the refundable credit would still most likely not create a refund solely based on the credit.
Let's walk through some examples.
We will start with a very basic example. Betty is single and her calculated tax due is $10,000. Her net total tax due is also $10,000 because she doesn't have any adjustments in the Tax and Credits section. Betty had $12,000 withheld by her employer and is not eligible for any refundable credits. Betty's net total tax due of $10,000 less the $12,000 withheld creates a refund of $2,000.
Now let's make Betty's scenario a little more complex. Betty is single and has one 8 year old child. Betty's calculated tax due is $10,000. Betty reduces that amount by the $3,000 Child Tax Credit she is eligible for. Her net total tax due is now $7,000. Betty then moves on to the Payments section of her tax return. Because Betty's W4 took her child into account, her withholding was only $6,000. Betty is also eligible for the Earned Income Credit (a refundable credit) and for ease of math we will say that amount is $4,000. So Betty has a net total tax due of $7,000 less the $6,000 that was withheld and then less the $4,000 Earned Income Credit. Her refund is $3,000.
In the first example, Betty's net total tax due of $10,000 was also how much she ultimately owed. In the second example, Betty's net total tax due of $7,000 was reduced further down to $3,000 because of the Earned Income Credit. In both examples though, Betty is getting a large refund. Making adjustments to her W4 with her employer could keep that money in her pocket (and her monthly budget) rather than getting a large lump sum back once a year.
People are much more likely to use their money with purpose if it is in their monthly budget rather than being in the form of a large refund once a year. The thing to remember is that if you don't make adjustments to your withholding and you continue to get a refund then have a plan for that refund every year. That plan could be putting the full amount towards some debt pay down such as credit cards or student loans, applying it to your child's 529 plan, or adding it to your own retirement savings. All in all, that tax refund is your money so don't blow it on a whim! Be intentional with it and assign that money a purpose whether your having less withheld and putting it back into your monthly budget or still taking that big refund at the end of the year.