April 15, tax day, is rapidly approaching. Interestingly, 3/4th of all taxpayers receive a refund each year with the average refund being greater than $2,000 (per “Nudge” by Thaler and Sunstein). That statistic may make it seem like most taxpayers are winners; but depending on your perspective, receiving a refund can actually be a loss.
As a CPA, I’ve learned that filing my taxes is merely a reconciliation between myself and the government. As I’ve been earning income during the past year I’ve been essentially prepaying the amount of taxes, through W-2 wages withholdings, that I’ll owe come tax time. If I prepay too much then the government will refund me the amount I overpaid. If I didn’t pay enough then the government will take my money for the difference. And if I didn’t prepay enough during the year Uncle Sam may even assess me a penalty (harsh).
Unless you have a significant amount of non-W2 related activity during the year (i.e. if you’re a business owner, own rental properties, win the lottery, etc.) your refund (or amount owed) will largely depend on the amount of taxes you withheld from your paychecks during the year. Consequently, “winning” your taxes will ultimately depend on your preference.
So which of the following do you prefer: 1) receiving a refund but taking home less money each paycheck; 2) maximizing your take home pay but owing when you file; or 3) paying just the right amount and therefore, not owing or getting a refund when you file.
Each option comes with its respective benefits and drawbacks. For option 1) although you may take home less money each paycheck, many people prefer this because they know they’ll be receiving a refund when they file. Many people who live paycheck-to-paycheck find this option helpful if they haven’t developed the habit of adequately saving so they “save” through setting aside extra money for their taxes and anticipate a refund each year. The primary drawback to this strategy is that by overpaying during the year you’ve essentially given the government an interest-free loan the past twelve months. You could have taken home more money, invested it elsewhere, and increased your income. For option 2) the benefits are the just the opposite of option 1’s primary drawback. You’ll take home more money with the opportunity to reinvest that money elsewhere to increase your income. The drawback of this option is when you file you’ll definitely owe the government money. If you don’t have the amount owed to the government in savings you’ll run into problems. And if you underpay by too much you’ll be assessed penalties when you file. Option 3) has become my goal. By paying the right amount during the year I balance between taking home more money each paycheck to make wise investment choices with my savings but also making sure I don’t owe the government when I file.
I’ve experienced all three of the aforementioned options. Our first year of marriage, my wife and I received a refund of $5K. I was ultra conservative with my taxes when I started my career and had the maximum amount of taxes withheld from my paychecks (single and zero marked on my W4) because I wanted to make sure that I wouldn’t owe any taxes (hence why we got a $5K refund). We’ve also had a year where we significantly underpaid during the year and owed over $2K when we filed our taxes. And we’ve had years where we were much closer to zero. As I’ve learned more about finances, my strategy has changed to trying to get closer to zero, which is what many financial experts recommend.
Taxes are confusing and it doesn’t appear they’ll get any less confusing with the passing of the Tax Cuts and Jobs Act. This is especially true as you progress through life’s stages (from being a student to working or being single to getting married to having children) and it can be tough to estimate how much you should withhold from you paychecks when circumstances change significantly from year-to-year.
Fortunately, the IRS has provided a tool to help you determine the number of withholdings you should list on your W-4: https://www.irs.gov/individuals/irs-withholding-calculator. While the IRS calculator may be helpful, it certainly is not sufficient for everyone. Taxes are personal and only you know what’s best for you. If your income has more complexity, such as income from a variety of sources I recommend consulting with a CPA to discuss your personal goals. I hope this article helps you understand the different options available to you and the benefits and drawbacks of those options.