Everyone loves tax time when it means they get money back from the IRS!
It's a great feeling to check your bank account balance and see that your refund has arrived!
Many big-box tax preparers feed into the frenzy by promising to get you "the biggest refund" or some other marketing hype.
But what exactly does getting a refund mean and why is it not all that it's chalked up to be?
First, let's talk about how taxes work on a basic level...
You earn money working at your job. Your employer withholds payroll taxes which are made up of FICA (Social Security and Medicare), State Unemployment Insurance, and Federal Income taxes. The FICA portion of the taxes are matched by your employer (so if $10 is withheld from your pay, your employer also pays $10). The Federal Income Taxes (and State Income Taxes if you are in a state with an income tax), are a pre-payment of taxes that you will owe on your income at the end of the year.
When your tax return is filed, your tax professional will look at your W-2 and report to the IRS how much money you made and how much tax you already have paid. They will reconcile that amount with how much tax you actually should have paid, and if you sent too much ahead of time (through payroll withholding), you will get a check back from the IRS.
Alternatively if you are a business owner, you sell your product or service, and you send in your estimated tax payments quarterly using a system like EFTPS, irs.gov/payments, or good old fashioned check. When your tax professional prepares your return they will look at your income, any business expenses and deductions, and take into account any other income you generated in the year. They will reconcile that against the amount you've already paid in through your estimated tax deposits and figure if you owe or will get a refund.
This is a very basic overview - there are other things that will come into play to determine your taxable income - things like how many dependents you have and what your filing status is and many other things. But the amount of income taxes that are withheld from your paycheck in the first place will be determined by these things.
Another item that could come into play is the Earned Income Credit. This is a refundable credit that some low-income taxpayers are eligible for. It can create a refund that is larger than the amount that you paid in through withholding or estimated tax payments.
Now that you know how the process of taxes works, let's talk about why getting a refund is a bad deal for you - the American taxpayer.
At the end of the day, getting a refund (barring special scenarios like the Earned Income Credit, etc.) means that you have given the government an interest-free loan all year. It means that you have had less money coming into your household budget than you were eligible for. It means that the government was able to put you money to use and you weren't.
The other problem with letting the government use your money all year until tax refund time is that you have no access to your funds. You can't make a withdrawal if you have an emergency or opportunity to use your money. You must wait until you are able to file your tax return and hope that the government is operating efficiently enough to send it back to you without too much delay. Even on the best year, the delay will be at least 3 weeks. Compare that to having the money in a bank account that you're able to withdraw for your use at any time.
This all may not seem like a big deal, but if you were able to keep that money in your own hands throughout the year, you could do things like invest it in a retirement account that would bear interest. That is making your money work for you!
I always want my clients to get as close to a $0 balance on their tax returns. I don't want them getting large refunds of money that they could have been putting to work for themselves throughout the year. I also don't want them having a large balance due and paying additional penalties for not paying enough in throughout the year.
It's a fine line and is one of the main reasons you should have a tax professional who is in your corner, especially if you are a business owner!
If your withholding is too high (meaning that you have too much withheld from your paychecks and you get a large refund every year), you might want to submit an updated W-4 to your employer. You can use the IRS' handy calculator to determine what you should put on your form.
What do you think? Are you going to try to get a smaller refund next year? How are you going to make sure that your money is working for you instead of for the government? Let me know in the comments!
