Who doesn't want a big refund?
It’s common for workers to set their withholding when they start a job and never revisit it. For many, this may have worked year over year if their income and life changed very little, leading to a usual, expected outcome when filing.
But then tax reform happened.
The Tax Cuts and Jobs Act (TCJA) adjusted tax withholdings from employee paychecks last year, throwing a wrench in the plans of many whose default had always been to go with the flow.
For those who didn’t check their withholdings, which is one of the biggest determinations of paying in or receiving a refund, the TCJA is providing a twist in the tale for many this tax season.
The truth: Strategy comes into play well before Tax Day arrives, and it has a profound effect on your outcome.
Some — like those who work with a certified public accountant (CPA) year-round — plan so there are few surprises.
Unfortunately, many others are passive in this process and hope for the best come tax time.
“We encourage our clients to plan ahead so they don’t get too much of a refund or have to cut too big of a check come tax time,” said Laura Nickolay, CPA, CFP, a financial adviser and senior tax associate with White Oaks Wealth Advisors Inc.
“If you are unable or unwilling to engage in tax planning, err on the side of too much withholding. Too little withholding can result in underpayment penalties and interest, whereas too much withholding generally has a positive outcome.”
As you complete your returns this year, take this opportunity to determine if your tax outcome is right for your situation and adjust your withholdings accordingly to prepare for next year.
To help, the Minnesota Society of CPAs has outlined what it means to receive a refund versus paying in. Keep in mind it’s highly subjective and depends on your specific situation.
Receiving a refund
A large tax refund means an overpayment of taxes throughout the calendar year, which could be a result of too much withholding.
•This operates as “built-in savings” for some people. When received, a refund can be used toward one-time purchases or investments, such as paying down debts or going on a vacation.
•Mentally this can serve as a big boost to see a deposit larger than your average paycheck.
•Overpaying taxes is not an ideal savings mechanism. A better option for putting money away is to invest or open an account that can yield at least a minimal return (and be of use in case of an emergency).
•For those living paycheck to paycheck, this is money you could have each paycheck to help make ends meet. An extra $50 each paycheck can go toward paying down high-interest debt, like credit cards or student loans, or it could help build an emergency fund.
“Zeroing out” means getting a minimal refund or paying in a minimal amount. It requires planning throughout the year — not just during tax season — and may require the assistance of a CPA or other tax professional.
•This option allows for the most control over your financial health. It takes the guesswork out of tax season, providing a safer path forward, instead of stumbling down an ominous trail toward an unknown financial forest.
•Taxpayers have access to their money throughout the year to spend, save or invest as they see fit.
•Planning provides peace of mind knowing there won’t be an unexpected, significant tax deficit come April.
•This isn’t an easy task to do alone. It’s difficult to perfectly zero out taxes, so some years may require a payment while others may see a small refund.
•Options like contributing more money to an IRA (individual retirement account) or HSA (health savings account), if eligible, can help decrease taxable income and get closer to zero. Taxpayers can contribute to these accounts until April 15 following the year for which they’re filing.
Paying in means an underpayment in taxes throughout the year, which could be caused by too little withholding.
•More money is in each paycheck throughout the year to save, spend or invest. However, if it leads to having to set up a payment plan with the government (see cons), then this may not really be a pro.
•If your 2018 taxes (filing now in 2019) is the first time you’re paying in, this is a planning opportunity to better understand your tax situation and revisit your Form W-4 withholding.
•There is a financial penalty for underpayment of taxes. There are different ways this can be calculated but, generally, the more owed, the more likely a taxpayer might be penalized under this rule.
•The IRS announced in January that it’s waiving the penalty for some Americans who unintentionally underpaid their 2018 tax liabilities. The waiver applies to taxpayers whose total withholding and estimated tax payments are at least 85 percent of the taxes they owe, according to the IRS. This leeway stems from the likelihood that calculations were more likely to be inaccurate because of federal tax reform.
•If the tax owed is more than the taxpayer has money available, they must decide how best to pay back the IRS and/or their state’s Department of Revenue. This may lead to setting up payment plans, which extends the possible financial hardship. And, delinquent payments to the government are subject to interest fees and additional penalties.
Consult a certified public accountant
“Each person’s situation is different,” said Nickolay. “If you historically use your tax refunds for home improvement projects or to increase your emergency savings, for example, but lack the discipline to save for those things throughout the year, you should continue to keep yourself in a refund position.”
Some people, however, prefer to manage their own money.
“If you’d rather have the flexibility that comes with larger paychecks, even if that means maybe writing a couple checks in April, that’s an option, too,” Nickolay said.
“However, being in the dark and not knowing generally what your tax situation will be is completely avoidable with proactive planning.”
The IRS has a “withholding calculator” available online that walks you through a series of questions to assist you in deciding the number of allowances you should claim so you have the proper amount of taxes withheld.
CPAs are also a great resource for those with a complex financial situation.
They can help you plan throughout the year so there are few surprises when it comes to filing a return, especially as it relates to properly withholding income taxes on your paycheck, planning for life events and helping you file an accurate tax return.