Understanding tax refunds is key to managing your finances effectively. A tax refund occurs when you have paid more in taxes throughout the year than your actual tax liability. While getting a big tax refund may seem like a windfall, it's important to understand that it's not necessarily the best financial strategy. Let’s break down how tax refunds work and why relying on a large refund might not be in your best interest.
When you work for an employer, taxes are automatically deducted from your paycheck. These withholdings cover federal and state taxes, among others. Essentially, your employer is paying the government on your behalf throughout the year. However, the amount withheld may not always match the exact amount of taxes you owe.
For example, let's consider someone earning $100,000 annually with a 20% income tax rate. If $20,000 is withheld by the employer for taxes, this amount is sent to the IRS. However, after taking a standard deduction of $24,000, their taxable income is reduced to $76,000.
Applying the 20% tax rate to this taxable income results in a tax liability of $15,200. Since the employer withheld $20,000, the employee is entitled to a tax refund of $4,800. Essentially, that refund is the money that you overpaid to the government, and they are simply returning it to you.
Many people see tax refunds as a financial bonus. However, it's important to remember that this is not "free money" — it's your own money being returned to you because you overpaid during the year. While it may feel rewarding to receive a large lump sum, there are several reasons why aiming for a big refund might not be the best idea:
In certain situations, tax refunds can be a financial benefit, particularly when refundable tax credits are involved. A refundable credit allows you to receive a refund even if it exceeds your tax liability. This typically applies to lower-income individuals and families with multiple children.
For instance, consider someone earning $15,000 annually with a tax liability of $1,500. If they qualify for a $3,500 Earned Income Credit, they will receive a refund of $2,000. In this case, the refundable credit provides a substantial financial boost beyond what they paid in taxes. Common refundable credits include the Child Tax Credit, Earned Income Credit, and the American Opportunity Credit.
On the other hand, most tax credits are non-refundable. These credits can reduce your tax liability to zero but will not generate a refund. Any unused portion of the credit can typically be carried over to the next tax year. For example, if your tax liability is $1,500 and you have a non-refundable credit of $3,500, your tax liability will be reduced to zero, but you won’t receive a refund. Instead, the remaining $2,000 will carry over to the following year to offset future taxes.
If you're finding yourself with either a large tax refund or owing a significant amount at the end of the year, there are ways to adjust your situation. The most effective step is to update your W-4 with your employer. The IRS has introduced a new W-4 form that takes into account your income, expected deductions, and other factors to better calculate your withholdings.
Additionally, the IRS provides a tax withholding estimator tool, which allows you to predict your tax situation mid-year and adjust your withholdings accordingly. By making these adjustments, you can ensure that you neither overpay nor underpay your taxes throughout the year. Remember to revisit and adjust your withholdings at the start of each year to stay consistent.
Managing your taxes effectively can save you money and help you reach your financial goals faster. If you need assistance with tax preparation or advice on how to adjust your withholdings, we’re here to help. Reach out to us at www.nguyencpas.com or support@nguyencpas.com to schedule a complimentary consultation with one of our advisors.
