Am I doing my taxes wrong? I am receiving around 1000 dollars in tax refund, and someone tells me it should be as close as to zero as possible, I thought the tax refund was government giving back most of the taxes that have been taken out of our paycheck? I guess I have been doing it wrong to maximize my refund? I only made ~9000 last year.
You don't "need" your refund to be as small as possible, but you usually would want it to be as small as possible.
The reason people say you should aim for a small refund is that getting a big refund means you paid more in taxes than you had to. This means you gave away money that you could have done something else with. You get the money back later as a tax refund, but you lost the ability to use it during the time the government had it.
For instance, if as you say you are getting a $1000 tax refund, that's $1000 that you are giving to the government over the course of the year. At the end of the year, you get it back, so you end the year with $1000. If you instead kept the money, (by paying only exactly as much tax as you owe throughout the year) you could invest it somehow, so that by the end of the year it could potentially have grown to, say, $1050. Thus at the end of the year you would have $1050 instead of $1000.
Ideally you would have zero refund and owe zero extra at the end of the year. However, since it is often difficult to make things work out so exactly, people often say you should aim for a small refund.
Assuming you are in the USA, if your income is only $9000 you will likely not owe any federal income tax at all, so you could claim exemption from withholding and avoid paying any tax ahead of time. You could check this when you file your taxes by seeing if the refund you get is equal to the total of taxes withheld from your paychecks over the course of last year.
Years ago, a coworker bragged to me how his "tax guy" got him a huge refund. I told him my goal was to owe a couple thousand dollars, and that I'm glad I didn't have his guy.
In the end, your return should reflect the truth, and a good tax guy will be little better than good tax software. The bottom line is that a refund is money you lend the government, interest free. If you can owe a bit of money but avoid paying a penalty, you'll have gotten a free loan from Uncle Sam.
Given the fact that most (it seems that way, someone tell me if I'm wrong) families carry some balance on their credit cards, they are paying out 12% or more on their highest interest debt. Lending the government even $1000 for the year comes at a cost, if you file in time to get your refund by the end of March, that's an average 9 months you are out your money. 12%/yr is $90. Scale that up to $3000, the average refund, and the max 24% rate I've seen, $540 lost. Better to adjust your withholding, and get the extra money each paycheck to pay off other debt.
Obviously, for those with no debt, their cost is minimal, perhaps 1%, but still better in your pocket for the year.
If you pay in this money every paycheck, only to feel good getting it back every March or April, while paying 18% card interest every month, that's your choice. And Stevej will support that decision, or so it seems.
EDIT - The Huffpost article Steve linked titled "Big Tax Refunds Really Are Good" ignores this debt, only focusing on the near zero rate banks offer now. The article listed 8 reasons the author felt this way. By the way, the author is the "Chief Tax Officer, Jackson Hewitt Tax Service Inc" which makes him a bit less than a disinterested third party. And all 8 of his reasons are far from compelling. "In my opinion, getting a $3,000 check is never a bad thing." This was #1, and by now you know why I disagree. Next, "More than 75 percent of all individual taxpayers get refunds year after year. It has been this way for decades.... It is unlikely that 75 percent of all taxpayers are all making bad financial decisions every year." That's enough. Rhetorical nonsense. Read the rest for yourself and decide if the next 6 reasons are any more compelling. Keep in mind, sellers of tax software or services have backed themselves into a corner with the "largest refund" claims. I'm sympathetic to the fact that "we'll shoot for no refund at all, in fact, our goal is for you to owe just $100" will not be their next campaign.
EDIT 2 - I gave this more thought as I started to write a near 1000 word post on this topic. I came to find that 1 in 4 employees did not deposit enough in their 401(k) to capture the full match. This is the highest lost opportunity as the potential return is an instant 100% for matched deposits. Again, it's easy to dismiss the near zero bank rates, but that's not the alternative best use for the money.
I would go even further: You should want to pay as much as possible with your return without having to pay a penalty. This lets you keep your money as long as possible without costing you anything extra. You don't want to overdo it and pay fees, so leave yourself some buffer. Still, try to get yourself in the mindset that paying at tax-time is a good thing!
Let's say you should have paid $4000 in taxes in a year, but you paid $5000, so you get a tax return of $1000. "Somebody" thinks that you should have tried to only pay $4000 in the year and get zero tax return. I hope he or she doesn't think you should pay $5000 and mess up your tax return so you get no refund.
Once the end of the tax year is there, you should do what you can to get as much tax returned as possible. On the other hand, you should also have tried to pay less during the year - obviously every dollar you paid less is a dollar less refund.
The pure numbers answer says you want the refund to be close to $0. You can even argue, as some answers have, that you want to try to maximize the payment without receiving any sanctions for underpaying during the year.
If you trace the money, it's easy to see why. Let's say you get a paycheck. Tag some of the dollars for Uncle Sam. These are the dollars that, eventually, will be given to the IRS. Now consider the following scenarios:
- You keep all of the money in your own accounts, leveraging that money. Perhaps your bank has a $2000 minimum deposit before incuring fees. You used to have to keep $2k of your money in the bank, doing nothing. Now, instead, you can put $2k of Uncle Sam's money in the bank, gaining utility from it. Then, near tax time, you make sure you have $2k of your own money in the bank, pay Uncle Sam.
- You withold all of the money tagged for Uncle Sam. You no longer get any benefit from that money. However, at tax time, Uncle Sam already has all the money he's going to ask for in his coffers.
- You withold even more money. Now, not only do you not benefit from that money, but in fact you're loosing access to money that wasn't tagged for Uncle Sam, but you gave it to him anyway! Then, at tax time, he hands you back the parts that weren't tagged. That money could have been providing leverage, such as investment or keeping banking fees away, but it didn't do so because you gave it to Uncle Sam, interest free, instead.
From the raw numbers like this, its clear that you lose utility by setting yourself up for a large refund check. The money was yours the entire time, but you chose to give it to Uncle Sam instead.
However, the raw numbers are only part of the puzzle. If you're a cold steely-gazed numbers person, they're the part that matters. When the billionares are playing their tax evasion games, this is the only thing they are paying attention to. However, real humans have a few psychological reasons they may choose to lose utility in terms of raw dollars in exchange for psychological assistance:
- Many have a hard time "earmarking" money. If the money is in the account, they use it. It's not ideal, but its how real people behave. In this case, they are using the IRS as a poor quality savings account. It's horrible fiscally, but they may be able to psychologically write it off as "its not my money," and then see a boon later.
- Some are not very good at saving for big things. I know many individuals choose to use the IRS piggy-bank as a way to save for large things that need to be done.
- Some view the emotional trauma of being in debt to the IRS to be a sufficiently brutal scenario that they would rather be confident that they're covered rather than taking the time to run the numbers and arrive at the logical answer.
These attitudes exist, and may be ideal for any one person. Obviously the financially savvy answer of "minimize your refund" is the ideal answer from a dollars and cents perspective, but its up to you to see whether that attitude is right when you account for all of the non-measurable things, like stress. In general, I would lead anyone to "minimize your refund," but I would be remiss if I didn't include the very real psychological reasons people choose to deviate from it.
It depends on when you're setting the goal.
1) When you have finished the year and you are filling out tax forms, your goal is to get as large of a refund as possible.
2) When the year begins afresh and you are earning money and paying taxes, your goal should be roughly to pay exactly the amount of tax owed so that at the end of the year you don't have any refund or tax owed - it's the same as getting your tax refund right away rather than waiting until after you file taxes. So you want your W4 set up appropriately (assuming you're talking about the US).
I think (1) is obvious. For (2), imagine you start the year with the goal to get the largest possible tax refund at the end. Well that's simple - fill out the W4 and on line 6 ("Additional amount, if any, you want withheld from each paycheck") tell them to withhold everything. Then at the end of the year you'll get a huge refund. Of course in the meantime, you've made an interest-free loan to the government, and you've probably had to take out a high-interest rate loan from your bank or credit card. Obviously this is bad.
An argument could be made that it would be even better to slightly underpay your taxes (but not enough to owe a penalty). Ignoring human weakness, this is correct. If you have the discipline to set that money aside in a safe place, that's okay. If this would cause you to spend that money (or even save less of your other money), then this is a bad idea.
So I'd really want to highlight some of this depends on your own financial discipline - is it better for you to have the money right away so that you can make good choices with how to use it now, or is it better for you to put the money somewhere out of reach so that you won't spend it on impulse purchases? (and recognize that there are ways to put it out of reach and earn interest on it rather than spending it - one good choice for you would be a Roth IRA)
Your question begins with a misunderstanding.
When you prepare your tax return (Form 1040/1040A/1040EZ) you always try to minimize your total tax bill.
When you fill out form W4 you trying to estimate how much tax will be shown on next years tax return.
The penalty for having too much tax withheld is not having the use of the money until you get a tax refund. At the moment interest rates are very low and your economic loss is the temporary loss of access to the money. One exception would be if you are carrying credit card debt. In that case you are, in effect, paying 20-30% interest to borrow money you lending to the US Treasury for 0% interest.
The penalty for having too little tax withheld is having to make a large payment with your tax return. If your pre-payments aren't at least as much as your total income tax from last year there may also be modest underpayment penalty based on the difference between your pre-payments and your total income tax from last year or this year whichever is less. A large underpayment will trigger a different larger underpayemnt penalty.
The W4 combined with the withholding rates tends to over-withhold income tax for most, but not all, taxpayers. Most people don't have enough savings to pay a large tax due, which leads to more penalties and an even larger bill. Over-witholding protects the overall tax system from the consequences of those events. People tend to be very unhappy, not quietly.
On balance your greatest economic benefit depends on whether or not you have high interest debt. If you do, then accurate and even slightly under-withholding will probably work to your advantage as long as you can pay next 4/15. If not, avoiding the chance of having any unexpected balance due next year may be more important.
Something I've not heard mentioned in any of the answers is that (at least for me) owing some tax money is better than having a refund from a ID theft/fraud/security aspect.
The US IRS has been hacked several times recently and there have been cases of fraudulent tax refunds being filed and tax refund checks being cashed by ID thieves. Well, if you owe a bit of tax then you're less of a target for fraudulent tax refunds being filed in your name.
Even in the case that you were unlucky enough to have had your identity stolen, at least you don't have to deal with the IRS trying to sort a mess like that up.
Thus, (IMO) it's better to owe a bit of tax, than to have a small refund, or any refund for that matter. Ideally, you want to get to zero dollars owed like you suggested, but that's often pretty hard to do. So, the next best thing is to owe a bit.
One should try to calculate tax liability quartely or if income changes, adjust your withholding, so that you get closer to zero tax.
Having a large state return also means that there is a potential income tax liability created at the federal level for the following year, as the situation resulted from the deduction of more on one's federal return than should have been deducted. The state refund is treated as federal income in the year it is refunded.
Set aside any perceived positive aspects of being owed a refund and weigh those with the negatives. What are the reasons you should not have your money tied up with the IRS? You'll see that Uncle Sam does not have a good track record as a financial institution:
- Has a history of delayed repayment.
Many thousands of refunds every year are delayed for many months due to IRS systems glitches. Yet, many people count on that refund which is not always guaranteed within the stated time-frame.
- Is above the law
You have no legal recourse. You cannot sue the federal government for the money you lent them when they decide not to pay you back for an extended period of time. Yet, if you decide to delay paying them, they have all the power and will use it to charge you fee's that no corporate / private institution would get away with.
- Has a history of fraud see SteveJ's answer above.
"owing some tax money is better than having a refund from a ID theft/fraud/security aspect"
- Will not pay you interest
Again, there is zero financial incentive to lend free money to Uncle Sam, he is not a bank. The only time interest comes into play is when the refund is overdue. Even then, it is not an incentive / doesn't come close to the penalty burden on you if you don't pay your taxes on time.
I would ask the followup question: What sane person would engage in business with such a financial institution?
I contend that there is great value in over-paying during the year and reaping a bigger refund.
I'm an engineer and understand the concept interest earned, blah blah. But for most of us, this isn't reality. The reality is that we spend what we earn, plus a little more.
At the end of each month, if the typical American has money left over - we spend it. We don't faithfully put that money that we would have payed into taxes to good use (such as savings or paying off that credit card).
Getting that big refund at the end of the year tends encourage us to make that one-time large payment to that high interest account, or to purchase that item that we otherwise wouldn't have saved for (or purchased with a credit card).
I say, give Uncle Sam the free interest - you'll have wasted that money during the year anyway - and enjoy a nice healthy refund that you can put to use for something you enjoy.
Life is just too short.