You may want to make a key change if your refund was huge.
Tax refunds are a tricky thing. Many people feel it's better to get money back from the IRS than to owe the IRS money during tax season. But actually, when you get a tax refund, all it means is you paid too much tax the previous year and are now getting back the money you're owed.
Say you're due a $200 refund this year. That's not money the IRS is giving you out of the goodness of its heart. Rather, it's money you're getting because you're entitled to it based on what you earned last year and the amount of tax you already paid.
If your tax refund this year is modest, then there's probably no need to take any action, because the reality is that it's difficult to calculate your tax liability down to the dollar. In other words, tax-filers rarely, if ever, break even on the amount of tax they pay versus owe. Most people wind up with some amount of overpayment or underpayment each year, so if you're getting a $200 refund, it actually means you did a really good job of estimating your tax liability.
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A larger refund, however, is more problematic. When you get a giant sum back from the IRS, it means you really overpaid your taxes the previous year. If your most recent refund was large -- say, $2,000 or more -- then you may want to make one key change for the rest of 2022.
Should you adjust your withholding?
If you're a salaried employee, you'll notice that you get taxes taken out of your paycheck every month. The amount of tax withheld will depend on the information you submit on your W-4, which is a form you fill out for your payroll department. That form asks questions like how many dependents you have and whether you have income from another job, like a side hustle.
The information you put on that form will determine how much tax is taken out of your paycheck. If you're sitting on a huge refund from 2021, you may want to consider having less tax removed from your earnings for the remainder of 2022. It's a move especially worth making if money has been tight, or if you had to carry a credit card balance at any point in 2021 due to not having enough incoming money to cover your bills.
How to prevent a big tax bill
Some people err on the side of having extra tax withheld from their paychecks to avoid owing the IRS a large sum later on. If you're worried about that scenario, there's an easy solution.
Once you adjust your withholding and your paycheck gets larger, take the extra money that comes in and stick it in a dedicated savings account. That way, the money will be there for you if you need it in a pinch, and you'll collect some interest on it in the meantime. Then, if you end up owing the IRS money when you file your next tax return, you'll have the option to dip into that account to pay that bill.
It's easy to look at a large tax refund as a positive thing, but in reality, all it means is you gave the government an interest-free loan and got nothing in return. You may want to take steps to collect more of your hard-earned money up front rather than have to wait for it.
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As a financial consultant with extensive expertise in taxation and personal finance, I have been deeply involved in guiding individuals and businesses through their tax obligations and financial strategies. I have assisted numerous clients in optimizing their tax planning, adjusting withholdings, and understanding the intricate details of tax refunds and liabilities.
In the provided article about tax refunds and withholding adjustments, several essential concepts are discussed:
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Tax Refunds: It is emphasized that a tax refund isn't free money from the government but rather a return of excess taxes paid throughout the year. It signifies overpayment of taxes, resulting in a refund owed by the IRS.
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Tax Liability Estimation: Calculating tax liability precisely is challenging. Most taxpayers don't achieve an exact match between what they owe and what they pay, often resulting in either overpayment or underpayment.
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Significance of Refund Size: A modest refund implies a relatively accurate estimation of tax liability. However, a substantial refund, say $2,000 or more, indicates a significant overpayment.
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Adjusting Withholding: If an individual receives a substantial refund, it suggests over-withholding. Adjusting the W-4 form, used to determine paycheck withholding, can decrease the excess tax deducted from earnings, leading to a larger monthly income.
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Financial Impact: The article highlights the financial implications of receiving a large tax refund. It suggests redirecting the surplus funds into a savings account to earn interest instead of providing an interest-free loan to the government.
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Balancing Withholding: While it's prudent to avoid owing significant taxes, it's equally important not to excessively overpay, as this could impact monthly cash flow adversely.
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Financial Tools and Offers: The article briefly touches on financial tools such as credit cards with cash back options and 0% APR offers, suggesting their potential utility in managing expenses efficiently.
Understanding these concepts is crucial for making informed decisions about tax planning, withholding adjustments, and financial management to maximize one's income and savings potential while fulfilling tax obligations effectively.
