At a time when cash is likely at a premium, it is time to think about filing your tax returns for 2020 and also time to think about how to maximize your cash flow for 2021. Richard Tullierr, CPA explains why it’s not good to get a big refund check.
We are bombarded nowadays with commercials showing people getting large refund checks, and when I see those commercials, I laugh. Those people are just getting back the 0% loan they gave to the government. So how do you keep the money in your pocket all year? WITHHOLDING
First, let’s go over how taxes work. We estimate our taxes on our taxable income (earnings less deductions) during the year to the federal government in the form of withholding.
Think about when you rent something and pay a deposit. That deposit is held until you return the item; it then may go towards paying the total amount you owe, or you may get a refund. Taxes work in a similar way. Your employer withholds taxes based on a set of criteria you give them. If you have too much paid in at year end, you get a refund. If you didn’t pay in enough, you will have to pay more.
So, no matter how much you paid in or did not pay during the year, your tax burden is the same. What changes is whether you get money back or owe based on how much you withheld during the year.
Here’s an example: Let’s assume you are Single and are paid $2,000 twice a month which amounts to a salary of $48,000. After the standard deduction, you have taxable income of $35,600 and a tax of $4,075. No matter what, this tax number will not change, regardless of your withholding. The following two scenarios show how withholding can put more money in your pocket during the year:
- If you withhold at the rates for Single with zero exemptions under a W-4 not updated since 2019, you would withhold $226 per period for a total of $5,424 taken out of your checks. When you file your tax return, you will get a refund of $1,349.
- If you withhold at the rates for Single under a W-4 completed in 2020 or later, you would withhold $170 per period for a total of $4,080 taken out of your checks. When you file your tax return, you will get a refund of $5.
At first, you might say, “Wait, I’m getting a smaller refund at year-end, so I did worse than my friends.” Unfortunately, you would be mistaken. If you look at the two scenarios closely, you will see that in Scenario 2 you received an extra $56 in each paycheck during the year, amounting to an annual amount of $1,344. Money in your pocket shows it’s not good to get a big refund check. These amounts may seem small, but when you have kids, or higher income (higher withholding), or other deductions, the disparity gets larger.
Now for those who are asking, “But how do I figure out how much to withhold?” I would recommend going to the IRS website and use the withholding calculator (https://www.irs.gov/individuals/irs-withholding-calculator) to help you determine the right elections to make with your payroll department.
No matter what you decide, please remember that your tax situation is unique, and just because a friend or someone in a news story said something happened to them doesn’t mean it will happen to you and you don’t know all of the facts. In general, it’s not good to get a big refund check. If you are interested in learning more, please feel free to contact us at Wegmann Dazet and we’ll be happy to take a look at your situation.