Stop Celebrating Your Tax Refund

Around tax time each year, millions of Americans eagerly await their tax refund check, as if it’s a gift from the government.

In fact, receiving a refund means that you overpaid your taxes. You have given the IRS an interest-free loan.  If you are feeling generous and don’t have a problem with loaning the IRS a few thousand dollars each year, then by all means, carry on.

However, if you would like to make that refund money work for YOU throughout the year, rather than for the IRS, then it might be worthwhile to make some adjustments. If you are a W-2 employee, here’s how to do it.

Step 1: Muddle Through The W-4

If you’ve ever been an employee, you’ve no doubt filled out this cumbersome form.

The purpose of the W-4 is to determine your number of withholding allowances, ranging from zero to 10 or more. Generally, things that reduce your federal taxes (like having a large mortgage, having kids, making large contributions to charity, etc.) will increase your withholding allowances.

The higher your number of withholding allowances, the LESS federal income taxes are withheld from your paycheck, and the MORE money you get to keep with each paycheck.

It is important to understand a few things about withholding allowances:

1. Withholding allowances only affect your federal income tax withholding.  They do not affect the  amount of payroll taxes (Social Security and Medicare) that are withheld from your paycheck.
2. The W-4 simply provides an estimate of the appropriate amount to withhold from each paycheck so that you don’t owe money or receive a refund at the end of the year. It just gets you in the ballpark.  You will be able to refine this later on, as explained below.
3. If you are single, unmarried, and have no kids, you can’t just put down some unrealistically high number of withholding allowances and keep your entire paycheck with no federal taxes applied.  The IRS is smarter than this and will punish you at the end of the year.  You have to make a good faith effort to have the appropriate amount of taxes withheld throughout the year.

Step 2: Fine-Tune Your Withholding Allowances

Remember, the W-4 only provides an estimate of your appropriate number of withholding allowances.  This may need to be adjusted.  Use your last paycheck and the IRS’ Withholding calculator to fine-tune your number of withholding allowances.

After entering in the requested information, the calculator will tell you if you need to increase or decrease your withholding allowances and by how much to get as close to neither owing nor receiving a refund at the end of the year.

Step 3: Determine Your Net Federal Income Tax Rate

If you expect to make approximately the same amount as last year, and your personal situation has not changed significantly (for example, you didn’t have kids, buy a house, or start a side business), then you can compute your net federal income tax rate from your previous years’ tax return, as follows:

1. Find your Total Income (Line 22)
2. Find your Total Taxes (Line 63)
3. Net Federal Income Tax Rate = Total Taxes / Total Income

Once you know your net federal income tax rate, you can tell your employer to take that EXACT percentage out of every paycheck.

This will be the MOST accurate way to make sure that you neither owe or receive a refund at the end of the year.  If you really want to make sure the IRS doesn’t take any extra money than it needs, drop it down a percentage point.

Note that if you use this method, the withholding allowances as explained above become irrelevant.

Step 4: Avoid the Underpayment Penalty

It is possible to become too overzealous and have too little federal income tax withheld, thus owing a large amount at the end of the year.  There are two potential problems with this:

1. You may not be able to pay the large tax bill: A large tax bill may not be a problem if you’ve been saving the money that wasn’t loaned to Uncle Sam.  However, if you’ve been spending it and you get a $10,000 tax bill at the end of the year that you can’t pay, then you have a problem.
2. You may be hit with an underpayment penalty: The IRS wants its money and doesn’t want to give you a large interest-free loan either.  Therefore, if you pay too little tax, you will be hit with a fine.

You will avoid this penalty if either of the following applies:

1. You paid at least 90% of your total current year federal tax owed
2. You paid at least 100% of the tax you paid last year (110% if you make over $150,000/year)

The most surefire way to avoid the penalty is fill out the W-4 as accurately as possible, use the IRS withholding calculator to refine, and if you have a prior tax return, use your net federal income tax rate for highest accuracy.

If your income is increasing from year to year (good for you!), such that your net federal income tax rate is also increasing, just make sure you pay at least 100% (or 110% if income >$150,000) of your prior year’s taxes to avoid the penalty.  You can do a quick check on your paystub towards the end of the year to make sure you are on track.  If not, you can simply send in an additional tax payment to the IRS.

Step 5: Make Sure to Put That Money to Work!

Having extra money in your pocket instead of loaning it to the IRS is not a license to spend that money on frivolous things.  The whole point is to use the money to pay down high interest debt (like credit card debt) or invest.

Some people like the idea of receiving a tax refund at the end of the year because it forces them to save.  I understand the concept of forced savings, but there are other more productive ways to do it.

For example, increase the percentage of your paycheck devoted to your 401k.  Since you will never see this money, this will also act as a forced savings method.  If you already max out your 401k, you can set up an automatic transfer each month from your checking account to your Roth IRA or taxable account.

Summary

Receiving a tax refund at the end of the year should not be celebrated.

If you have a prior year tax return and your tax situation has not significantly changed, figure out your net federal income tax rate and use that percentage instead of  the withholding allowances for greatest accuracy. If your income is increasing, make sure you pay at least 100% (or 110% if a high earner) of your prior years’ federal income taxes to avoid any underpayment penalties.

If you do not have a prior year tax return, or your tax situation has changed significantly, then fill out your W-4 as accurately as possible and check your withholding allowances using the IRS’ Withholding calculator.

In any case, stop giving the IRS an interest-free loan. You have more productive uses for that money.

Remember, it’s Not About the Money; It’s About the Freedom.