How Do Tax Refunds Work?
Let’s talk about how tax refunds work and why it might not be a good idea to have a big tax refund. To do that, let's take a look at an example that shows how income taxes are handled when you are paid by an employer. Now that you know how a refund works, let's talk about some of the reasons people use to justify why it's a good idea to get a large refund. The first one I hear a lot is that it's like getting a "bonus” at the beginning of the year. This is not entirely true because this is your money that was given to the government and they’re just giving it back to you. So it’s not a bonus. Another justification we hear is that it ensures that I save money. Once you get the refund, what do you do with the money? Do you spend it on something crazy, or do you put it in a savings account? Sometimes people need more extreme measures to help them save money and this is kind of like out of sight out of mind, but there are much better ways to save your money. One thing you can do is have your employer direct deposit the excess money into a separate savings account. If you have direct deposit, you can have your pay deposited into multiple accounts. Another option is just to have it all direct deposited into your main checking account and have automatic transfers out to a brokerage account, or savings account every month. Those are some much better options because you can earn money on your money rather than “loaning” it to the IRS for the year. The last thing I hear people say a lot is that they like to buy themselves a nice treat with their tax refund money. And you know, you've just got to ask yourself is that really the best use of your money? Even if you choose to buy yourself something special, wouldn’t it make more sense to have that money earning in a savings or brokerage account throughout the year and then purchase that special something once you’ve saved enough?If you work at a job where you receive a W-2, you have your federal and state taxes withheld from your paycheck every time you get paid. Your employer takes your taxes from your paycheck and pays the government for you. For this example, we are going to simplify things and just look at federal taxes assuming a straight 20% income tax rate. In our example above, the individual has an annual salary of $100,000 and $20,000 of taxes were withheld and paid to the IRS, by his employer. When he files his tax return at the beginning of the following year, he's going to report his salary of $100,000 and he's going to take a standard deduction of $24,000. So, you subtract the standard deduction from the total salary paid to calculate your taxable income bringing his total income to $76,000. To determine the federal taxes due, you take 20% of the $76,000 or taxable income amount. So according to the tax return calculations in our table above, this person owes $15,200 in taxes but his employer withheld $20,000. What happens to the extra $4,800 withheld by his employer? It gets returned to the employee by way of a tax refund. Tax refunds are not "free money". It is your money that you overpaid to the government throughout the year and the government gives back to you when you file your tax return.Refundable CreditsLet’s talk about refundable credits. In some instances, a tax refund is not all bad. There are some situations where people will get a large tax refund, when their tax liability wasn't that great. A refundable credit is a credit that you receive as a refund even if it's greater than your tax liability. This usually applies when you have lower income and multiple children. So, this is one scenario where a big refund is a good thing. Take a look at the example below.Refundable Tax CreditsSalary:15000Tax Liability:1500Earned Income Credit:-3500Total Refund:-2000In this very simple example, we have somebody making a $15,000 salary and let's say their tax liability is $1,500 or 10%. They have one child and qualify for the earned income credit of $3,500. Remember, their tax liability is only $1,500. So, because the earned income credit is a refundable credit, this person will receive a refund of $2,000, even though their tax liability was only $1,500. The three main refundable credits are the child tax credit, the earned income credit, and the American opportunity credit. In these instances, you don't need to adjust anything on your W-4.Non-Refundable Tax CreditIn most cases, tax credits are non-refundable which means that your tax liability will be reduced to zero but you won't receive a refund. Any excess non-refundable tax credit will be carried over to offset the following year’s tax liability. Let’s look at our example and change the tax credit to a non-refundable credit.Non-Refundable Tax CreditsSalary:15000Tax Liability:1500Non-refundable credit-3500Total Refund:0Carryover:-2,000So, you have a tax liability of $1,500, a non-refundable credit of $3,500, giving you a refund of $0. The credit is greater than the tax liability, so it covers the entire tax liability for the year and leaves you with a $2,000 credit carryover to the following year. In the following year if your tax liability increases then the credit that you carried over will offset some of that increased tax. The non-refundable tax credit will keep carrying forward from year to year until it's used up.How to Fix Your Refund SituationSo, let's say you're not in a refundable credit situation, and you do have either a huge refund at the end of the year, or you are owing a lot of taxes at the end of the year. What can you really do about this?The main thing you can do is to adjust your W-4 with your employer. The IRS came out with a new W-4, which uses your actual income numbers, your expected deductions, and it calculates your withholdings using those numbers. Another thing you can do is use the IRS tax withholding estimator tool to evaluate mid-year what's going to happen at the end of the year when you file your taxes. It's a good way to get a prediction whether or not you're going to get a large refund, or you're going to owe a lot. From that point you can determine how much more withholding or how much less withholding you should be taking from your employer for the remainder of the year. It is important to remember that if you adjust your withholdings mid-year that you re-evaluate and adjust them at the beginning of the following year to make sure it's consistent.We are here to help. If you need assistance in preparing and submitting tax returns, reach out to us at www.nguyencpas.com or firstname.lastname@example.org and schedule a complimentary consultation with one of our advisors.