Avoiding Getting a Big Tax Refund
For the next installment in our Personal Finance Mistake Series, I’ll discuss our checkered past with willfully getting a big tax refund. While not required reading for this article, you might find it informative to read our first and second installments in this series on personal finance mistakes, if you haven’t already.
Big Tax Refund Euphoria
There’s no doubt seeing a non-zero number on line 75 of your Form 1040 can feel pretty good at tax filing time. If it is a big tax refund, it can feel even better. We’ve been able to experience that good feeling many times. In fact, I looked back over the last two decades of our tax returns and found I had received over $40,000 dollars in refunds from the IRS. Forty thousand dollars! That’s a lot of refund euphoria. Well, at least until I bothered to realize I was giving our government an interest free loan on $40,000. Wait, what!?
That’s right, all those big tax refunds are a nice interest free loan to our fine government. Uncle Sam got free use of your money through the year and you got what? Nothing.
In fact, it could have been worse than nothing. For those living paycheck to paycheck, that big tax refund may have caused you to carry a balance on a credit card, or to defer savings towards retirement or another important goal. Bleck to both.
Why Were We Getting a Big Tax Refund?
To stop getting big tax refunds each year, I had to understand why we were getting them. In our case, we each collect a paycheck and have taxes withheld. The amount of federal taxes withheld is largely determined by the Form W-4 that is filled out and submitted to our employers. Many people (us included) filled the form out once when starting a job and then rarely updated it.
Since I didn’t want to underpay by even a little (mistake!), I marked “Married – 0 Allowances” for both of us. With two kids, lots of itemized deductions, and very little dividend/interest income, we netted a nice big tax refund year after year.
How to Better Estimate Tax Withholding
So what should I have done differently? Spend some quality time with the Form W-4, that’s what. For us, it turns out, if we actually take the time to use the included worksheets that come with the Form W-4, it cleverly does a rather good job of estimating the withholding amount for the year. In fact, the first time I updated our W-4s, we started taking home an additional $200 a month. At tax time, we owed a very manageable $250 to Uncle Sam.
The next year, thinking all was well, I didn’t touch anything. But at tax time, we got a whopping $1800 refund. What happened?
Life happened! We gained another tax deduction that year and a bonus Jenny had received the previous year did not materialize. As a result of not getting that bonus, we were actually in a lower marginal tax bracket. Things could have gone the other way, though. And they often do for many people. Deductions change, you may get a raise at your job, or even experience job loss and a reduction in income. How do you compensate and have only a small refund or tax bill? You guessed it – update that Form W-4.
Recommended Habits and Tools for Accurate Tax Withholding
A good practice is to revisit your W-4 any time a significant event occurs that could affect your taxes. If changes adding up to more than a few hundred dollars occurred, give an updated W-4 to your employer. A list of possible things that could cause your estimates to change:
- Marriage or Divorce
- Birth of or Emancipation of a Child
- Death in the Family
- New Job or Job Loss
- Change in Salary
- Bonuses or Awards
- Purchase or Sale of a Home
- Capital Gains or Losses
In our case, at tax time I use a withholding calculator that’s part of our tax preparation software to check up on our W-4. That way what I’m owing or getting back that year is fresh in my mind. It’s also a good idea to just review your W-4 mid-year to see if the projections you assumed at the beginning of the year are still holding up.
Here are links to Form W-4 and other IRS tools and publications helpful for people with more complicated tax situations.
Form W-4 Employee’s Withholding Allowance Certificate
Publication 505 Tax Withholding and Estimated Tax
Don’t Forget About State and Local Taxes
Many of us live in a state with state income tax. Cities and municipalities also frequently levy income taxes. The magnitude of state tax withholding is often considerably lower than your federal taxes. But, don’t forget to update the state equivalent of the withholding allowance certificate to prevent a big tax refund or bill from your state. Your employer, or your state department of taxation, can provide the necessary form.
If you pay city or local income taxes and you are getting a refund each year, contact that municipality or your employer for the possibility of reducing your withholding. Cities and local tax authorities are not always as flexible as states and the federal IRS on withholding adjustments, so changes may not be easily made. Fortunately, the withholding for these taxes is likely the smallest of the income tax withholding you pay.
What About Those Making Quarterly Estimated Tax Payments?
The self-employed and retired frequently must pay quarterly estimated taxes. As a result, it essentially forces a recalculation of estimated taxes four times a year. It is in lieu of the tax withholding employers do for every paycheck they give you. I have not done quarterly filing before, but similar to the Form W-4, there are opportunities to dial in your withholding to avoid a big tax refund. IRS Publication 505 has additional information for people in this situation.
Wrapping It Up
With just a bit of work using the tools provided by the federal IRS and state and local tax departments, I was able to go from giving the government free loans via big tax refunds to just relatively small refunds and bills each year. This put our money in our pockets throughout the year to be used for daily expenses, saving, or investing.
Another side benefit of getting small tax refunds or bills is that it allows your budgeting to be more consistent through the year. Getting a big slug of money back from the government each year just complicates budgeting and causes unnecessary stress for paying bills the rest of the year.
What has been your experience with getting big tax refunds?
Posted by Jeff