Think twice before celebrating that large refund check from Uncle Sam.
The IRS had doled out 45.5 million refunds as of Feb. 28, with the average refund check totaling $3,064. That amount is just $4 less than last year’s average refund.
Filers have reasons to celebrate their small windfall. Most have ambitious plans for their small windfall, including shoring up their savings and paying off debt.
Here’s the downside of getting a large check from the IRS: It means you voluntarily overpaid the taxman last year.
“Most people are really happy about the refund because it’s money going back to them,” said Sean Stein Smith, CPA and member of the American Institute of CPAs’ financial literacy commission.
“But any refund you’re getting back is because you had too much tax withheld from your paycheck during the whole year,” he said.
Where’s the refund coming from?
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Whether you owe Uncle Sam or get money back in the spring will depend on a document your employer has on file, known as a Form W-4 or an employee’s withholding certificate.
Employers use this form along with the tax withholding tables to figure out how much income tax to pull from your paycheck.
The W-4 considers the number of dependents you have in your household, your filing status, income you generate and whether you’re claiming the standard or itemized deductions on your tax return.
Arriving at the ideal level of income tax withholding is as much art as it is science.
If you withhold far too little, you take home more money with each paycheck, but you run the risk of owing the IRS the following year.
If you withhold too much, you’re giving Uncle Sam more money than necessary. This gives you good odds for a large refund in the spring, but a smaller paycheck in the meantime.
It’s also worth noting that after the Tax Cuts and Jobs Act took effect in 2018, the IRS overhauled Form W-4 and its withholding calculator to reflect major changes to the tax code.
These changes include the roughly doubled standard deduction, the elimination of personal exemptions and new curbs on itemized deductions.
The new W-4 and the withholding calculator also account for side-gig or self-employed income you or your spouse may have.
You’re supposed to pay quarterly estimated taxes on this income — a requirement that moonlighting “9-to-5ers” may actually overlook.
“There is an extra line on W-4 where you can enter a flat amount that you want withheld form your paycheck,” said Andrea Coombes, tax specialist at NerdWallet. “That can help you get some of those estimated taxes paid and avoid a tax bill next year.”
How to figure out your taxes
A common misconception is that if your refund is high, then it must mean you’ve paid less in tax the prior year.
If anything, large refunds mean you’ve overpaid taxes.
However, if you really want to see how your taxes stand from one year to the next, look at line 16 of the Form 1040 — your income tax return for 2019 (line 15 on 2018’s 1040). This reports your total taxes paid.
Don’t forget to factor in the amount of income you’ve earned that year, too.
“It could be that your taxes went up because you have more income,” said Coombes. “It’s not necessarily bad news, but it could be something to think about.”
Review your 2019 tax return with your CPA or your tax preparer, as those results can help you strategize for next year.
Steps to consider might include lowering taxable income in the future by raising 401(k) plan contributions or socking money into health savings accounts and flexible spending accounts at work.
Aiming for zero
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Zero is the magic number for taxpayers.
The IRS’s withholding calculator can help you tailor your tax withholding so that you’re close to matching your federal liability.
The amount of taxes you pay to your state might be a different story, so talk to your tax professional to make sure you’re paying just the right amount.
“In an ideal world, your income taxes withheld from paychecks should cover your income tax liability for that year,” said Smith. “Ideally your refund or additional taxes owed should be zero or as close to zero as possible.”