Many tax filers assume that receiving an income tax refund is better than paying a balance due. Although a refund is preferable in the short run, it is effectively an interest-free loan granted to the government. In the longer run, tax filers can possess more money to spend throughout the year by recognizing the financial drawbacks of a tax refund.
The government pays no interest on tax refunds. The funds are tied up and inaccessible until you file a tax return to request the refund. From a financial planning perspective, you are generally better off by adjusting your tax withholding in order to reduce or eliminate the refund.
Earn interest on savings
Deliberately reducing your tax refund equates to increased take-home pay from each paycheck. The additional funds are able to earn interest in a savings account. More importantly, the funds are readily accessible for you and your family throughout the year.
Reduce tax withholding
The tax code has specific requirements for the withholding of income tax on earnings. If withholding is insufficient, an interest penalty can be assessed on the underpayment. Wealthy individuals often utilize a strategy of optimizing tax withholding. Any tax filer can use the same strategy, converting a future refund into current cash.
Avoid withholding penalties
There is no penalty if your final balance due with your tax return is less than $1,000. A suitable goal might be to aim for a break-even tax status. If your tax return shows either a small balance due or a small refund, the objective of reducing an excessive refund is achieved.
Even if your final balance due is over $1,000, no penalty is assessed if 90 percent of your total tax is already paid earlier in a timely manner. Total tax is not the same as the final amount due. Total tax is the full amount shown as kept by the government after the completion of your tax return.
There is also no underpayment penalty if your withholding for the current year equals or exceeds 100 percent of your total tax for the prior year. The prior year exception is different for individuals with over $150,000 in current year income. At the higher income, the exception applies if current year withholding exceeds 110 percent of total tax for the prior year.
Mandatory withholding on earnings can be adjusted by submitting a revised IRS Form W-4 to your employer. Estimated tax withholding for other types of income should be remitted quarterly as the income is received. Contact a financial planning consultant like Peterkin Financial for more information on how to ensure that your assets are working to your full advantage.
Share24 July 2015
I still remember the day that my wife and I bought our first home. We were excited about filling the place with new furniture and looking for great area rugs. Unfortunately, before we knew it, we found ourselves deeply in debt. It was difficult to dig our way out, but over the course of the next several years, we were able to make things right. I want to teach other people how to manage finances so that they can avoid the turmoil that we went through. Financial planning might seem impossible, but with a little practice, I know it can become second-nature.