Everybody pays taxes, yet not everyone fully understands them. When April comes, you file your taxes and cross your fingers as you anxiously await your results. It’s almost like a coin flip will determine whether you owe money or receive a refund.
This should not be the case at all. The reason why taxes scare so many individuals is a lack of understanding. The IRS does a great job of collecting your tax dollars, but a very poor job at explaining how the tax code works. Let’s take a look at three key areas to help take the guess work and apprehension out of filing your taxes:
- Why do I owe money or get a refund?
- Are tax refunds really as good as they seem?
- How can I avoid surprises come tax season?
What Determines the Amount You Owe/Get Refunded
April 15th gets a bad rap as the day most people pay their taxes. This isn’t exactly correct. You actually pay your taxes little by little throughout the year through what are called tax withholdings. A portion of each paycheck is deducted and put towards your tax bill for the year. Then, once a year, you file your taxes to determine exactly how much you owe. This amount is compared to the amount you already paid through your withholdings. If you paid too much, you get a refund. Too little–and you owe the difference.
How does your employer know how much to deduct from each paycheck? The short answer is they don’t. Your employer simply takes out the amount you tell them to on your Form W-4. This is a form you complete to estimate how much you will owe in taxes so that the correct amount can be withheld from each paycheck. The form asks for things such as the number of dependents you have and what your itemized deductions look like. Ultimately, your inputs on your W-4 play a huge role in whether you will receive a refund or not.
People often run into trouble when they have two jobs or have other sources of income such as rental properties, a side business, dividends/interest from investments, pensions, Social Security, etc. Your employer will withhold a certain percentage of the paycheck they give you, but they don’t know what other sources of income you have. This could lead to you still owing a lot in taxes come April, so make sure you account for all your income sources when choosing the correct withholdings. You can either have a little bit of money withheld from each income source, or just have your employer withhold an extra amount to compensate for your other income sources. You can decide based on whichever is more convenient for you.
Why Refunds Are Not as Good as You Think
Every year, around eight out of ten tax payers receive a refund when they file their taxes1. They jump for joy, almost like the IRS just gave them a surprise gift. However, should you really be so excited over your tax refund?
From a behavioral standpoint, of course you should be excited for getting money back. But let’s look at it from a financial perspective. Remember how filing your taxes every April is really just a way to see if the amount of tax you paid during the year is correct or not? Well that means that the refund you just received is money you overpaid to the government. Think of your tax bill like your utility bills. You wouldn’t be excited about overpaying your cable each month, would you? That is exactly what happens when you get a tax refund—and that’s not the worst of it.
That money you overpaid each month is money you could have kept in your pocket. You could have used it to go on a vacation, go out more, anything you want. More importantly, you could have used that money to invest. That’s money that could be growing each month, and that growth compounds. This is not the case when you give your money to the IRS each month. Essentially, you are giving Uncle Sam an interest-free loan when you could be using that money for your own enjoyment or investment.
How to Avoid Surprises Come Tax Time
Hopefully now you know how the system works, but how do you use this to your advantage? The two main ways to utilize the information you just read are a) to avoid unnecessary surprises when you file your taxes, and b) to make your money work as efficiently as possible throughout the year. Here are a few ideas to do both:
- Take the gamble out of filing your taxes by filling out your Form W-4 correctly and submitting it to your employer. You can even download the form online for free.
- Don’t forget to account for ALL your income sources when determining your withholdings. This may require you to make extra withholdings or estimated payments.
- Any time your tax situation changes (you get a raise, get married, take on a mortgage, have a child, etc.) make sure to update your W-4 to reflect this.
- Put your money to work instead of lending it to the IRS for nothing. Don’t use your tax refund as a method of forced savings. Instead, set up an automatic transfer to your investment accounts to make saving painless.
- Avoid penalties for paying too little tax throughout the year. We already talked about why refunds aren’t as great as they seem, but paying unnecessary penalties is even worse. Having the correct with-holdings can avoid this.
The biggest takeaway is this: you have more control over your taxes than you might think. It’s not a coin flip or a roll of the dice. It’s you. With a little work you can stop fearing tax season and the IRS. Taxes are a huge part of your life, and by learning to control them, you can begin to take charge of your financial future.