Around March and April every year, we often hear friends and colleagues excitedly proclaim the amount of the tax refund they expect to receive as a result of that year’s income tax return. A competition ensues as they discuss who is getting the largest refund, and what they plan to do with the money. Businesses often capitalize on this opportunity to advertise sales and offer promotions that will allow taxpayers to utilize their refunds for large purchases. However, should we really be pleased to receive large tax refunds year after year?
Paying Our Taxes
Most working Americans have the bulk of their income tax liability withheld from their paychecks, while retired taxpayers often have taxes withheld from their retirement checks or annuities. Some taxpayers, who have other activities such as small businesses, investments, or rental properties, may need to make estimated tax payments. But how much must we pay throughout the year?
The IRS operates on a pay-as-you-go mentality. That is, the IRS generally requires that individual taxpayers make tax payments throughout the year as
they receive the related income. According to IRS Publication 505 for 2017, you must make payments equal to at least 90 percent of what you expect to owe on your current year tax return, or 100 percent of what you owed on your previous year’s tax return, whichever is smaller. For example, if you owed $15,500 in taxes last year, but expect to owe $12,000 this year, you would have to ensure that your withholdings and any estimated payments at least equaled $10,800, or 90 percent of $12,000, for that same tax year. In contrast, if you owed $12,000 in taxes last year, but expect to owe $15,500, you would need to pay at least $12,000 in withholdings and estimated payments for the year. Paying the minimum amount of tax required by the IRS ensures that you will not incur an underpayment penalty upon filing your tax return. In general, you will only incur a penalty if you owe more than $1,000 in taxes; however, there are some special rules for certain taxpayers such as farmers and household employers. (Note: While these statements are based on the 2017 IRS Publication 505, the rules are not currently expected to change for the 2018 tax year.)
Currently, the average American taxpayer greatly overestimates the amount of income tax they will owe the federal government each year, resulting in excess withholdings and prepayments. This excess is then returned to them in the form of large refunds each year. An IRS report for 2016 tax returns filed through the end of 2017 showed that 73.64 percent of individual income tax returns resulted in tax refunds. The IRS refunded an astounding $323 billion, at an average of $2,895 per taxpayer. Ideally, individual taxpayers should only pay, through withholdings and estimated payments, the exact amount of taxes that will be owed upon filing the final tax return.
Why Refunds Can Be Bad
Many taxpayers like the idea of using the IRS as a savings account and receiving a large refund at the end of each tax year. However, basic principles of business and economics indicate that taxpayers are better off paying the minimum amount of taxes necessary throughout the year, and using the excess funds for wise investments. For example, Jamie Farmer, Managing Director of Index Data Services, noted that the Dow Jones Industrial Average saw an annual increase of 25.08 percent in 2017. While a significant return could have been earned on funds invested in the stock market within 2017, the IRS does not pay interest when income tax refunds are issued to taxpayers. This means that Americans who are overpaying their taxes are allowing the IRS to borrow their hard-earned income interest-free. In addition, home improvements and other large purchases could be made earlier in the year instead of waiting on the IRS to process the refund.
Making a Wise Choice
If you or your family have been receiving large refunds year after year, it may be time to consult with a tax professional. This can be especially helpful if you or your family experience a change in circumstances, such as a change in employment, the purchase or sale of a home or business, or a change in dependents. A CPA or tax preparer can assist you with determining the minimum amount of withholding and estimated payments necessary to avoid an underpayment penalty, while still maximizing the amount of after-tax dollars you are able to keep and use throughout the year. Instead of giving the IRS an interest-free loan, consider investing in your family’s future through a retirement plan, investments, or finally making those planned home improvements.
Disclaimer: This column is for informational purposes and should not be considered personalized tax advice. Everyone’s circumstance is different, and individuals should seek tax advice from a tax professional based on their unique financial situation.