For most of us, tax time is like the holidays. It’s a magical time of year when a jolly IRS employee in an ironed dress shirt and pressed slacks issues all of us taxpayers on the “nice” list a big fat check, courtesy of the federal government. For most of us, it’s a small windfall.
But have you ever stopped to ask yourself why you get that money, or what it means?
To understand the concept of a tax refund, you need to understand how income tax works.
Remember that W-4 form you fill out when you start a job? Not ringing a bell? Well, you most likely did or else your human resources and payroll departments would have a panic attack.
The W-4 is basically a calculator that is used to determine how much of your paycheck should be set aside to pay your income taxes at the end of the year. Life is complicated. Taxes are even more so. How much is withheld is affected by things like your marital status, how many kids you have and your eligibility for certain tax credits.
Based on the number of “exemptions” you claim, your employer sets aside more or less of your paycheck. The fewer exemptions, the more they take. You’re essentially pre-paying your taxes. But it’s not an exact amount, it’s an estimate. Things could change and your tax liability could go up or down.
You fill out your tax return every year to declare your income and figure out what your final liability is to the federal government. This is where you claim all of your deductions and credits with the aim of getting your taxable income down to the smallest amount legally possible.
The reason we get money back is because we overpaid the government. That’s why it’s called a refund and not a surprise or a present. That refund is essentially a 0% interest loan that we gave the Treasury. But it doesn’t have to be like that; you have a choice.
Big Refund, Smaller Paycheck
The best way to maximize the size of your refund is to claim few, or zero, exemptions on your W-4 form. You technically don’t have to claim any, even if you’re entitled to them. That just means you’ll get a smaller paycheck, but a windfall (hopefully) when you file your tax return.
This is the way to go if you rely on that money each year to make big purchases, put in savings or pay off some debt. But remember, you’re lending the government money at no interest.
Bigger Paycheck, Smaller (or No) Refund
If you get a tax refund every year, you might be able to spread that out over your paychecks. To do this, claim the maximum number of exemptions you’re entitled to on your W-4. This means your company’s payroll department will set aside the least amount of tax possible, depending on your circumstances. You’ll get more in your paycheck, but a smaller, or no, refund.
Be careful though, your tax liability could be affected by any number of factors and if you haven’t had enough taken out of your paychecks, you could end up owing the government. Then it’s you who’ll have received that 0% interest loan, not Uncle Sam.
If you’re looking to make a change, it’s not a bad idea to consult your accountant or financial planner before you submit a new W-4. There are lots of factors to consider. Also, Turbo Tax has a number of cool (and free) tools to help you make sense of withholding and help you estimate what you might get back or owe.
Which path you choose depends on your financial personality type and your budgeting preferences.
So which type of person are you? Would you like it in a lump sum, or spread out? Tell us in the comments!