Are Tax Refunds Good or Bad?
Few people pay exactly the correct amount of income tax during the year. When you file your return for 2014, you probably will find that you paid too little (and owe more tax) or paid too much (and can request a refund). Typically, refunds are due to employees who have too much tax withheld from their paychecks.
Example 1: Arlene King is paid twice a month. From each paycheck, her employer withholds $1,000 for federal income tax, so Arlene’s tax payments for 2014 were $24,000. When Arlene files her 2014 tax return, she sees that her tax obligation for last year was $21,000. Thus, Arlene can request a $3,000 tax refund.
Does over-withholding and getting a refund in this manner make sense financially? That depends on a taxpayer’s situation.
The advantage of getting a tax refund is, well, who wouldn’t want to receive a large check from the federal government? Moreover, federal income tax refunds aren’t taxable. (A state or local tax refund may increase the tax you’ll owe.)
Thus, Arlene may decide to use her $3,000 refund check to invest or to pay down debt or to make a special purchase. In effect, her $3,000 of excess tax withholding becomes a form of forced saving, which she can utilize every year when the check comes in.
Now for the negatives
- On the other hand, having too much money withheld for income tax has been likened to making an interest-free loan to the IRS. It’s your money—you earned it—so why wait for months to get your hands on it? This strategy can be especially unappealing if your over-withholding results from a major change in your life.
Example 2: In early 2014, Bianca and Craig Carter bought a house, using a large mortgage for the purchase. Bianca left her job to stay home with their young child. Thus, the Carters had lower income and higher deductions than in 2013, resulting in a smaller tax bill.
However, Craig did not adjust his tax withholding at work. Thus, he paid more tax than necessary throughout the year. It’s true that the Carters will get back the overpayment with a 2015 tax refund, but they went through 2014 with less cash flow than required, forcing them to struggle to cover the costs of a new home and a growing family.
- Identity theft by filing fraudulent refund claims has generated massive problems for taxpayers. If you are subject to identity theft, the receipt of your refund will be delayed by months. You don’t have to reimburse the IRS for the stolen funds but they will not release your refund until they verify your identity and claim.
Winning the numbers game
If you feel that you need the disciplined forced savings of over-withholding, then relying on an annual tax refund may make sense. Be aware of the added risk of the possible delay in payment. Conversely, if you prefer to get your money as you earn it, you can reduce the amount withheld by filling out IRS Form W-4, Employee’s Withholding Allowance Certificate, and submitting it to your employer. Our office can help you fill out Form W-4 so you get the right amount withheld, avoiding either a large refund or a large tax obligation with next year’s tax return.
Trusted advice: Adapting allowances
- On IRS Form W-4, employees can claim a number of personal allowances.
- The more allowances you claim, the lower your withholding and the more income you’ll receive with each paycheck.
- Two income couples can calculate the total number of allowances to which they’re entitled.
- For such couples, withholding usually will be most accurate when all allowances are claimed on the Form W-4 for the higher earning spouse.
- The lower earning spouse then can claim zero allowances on his or her Form W-4.