How’s your Refund?

I find a lot of my clients misunderstand tax refunds. If you don’t work with these things every day, it can be difficult to understand the relationship between your tax liability and your refund. Think of your taxes in three separate chunks:

I WITHHOLDING

US tax collection is a “pay as you go” system which facilitates the orderly collection of taxes. Most of us pay income taxes out of our payroll check. You can see this amount under the “FED W/H” line of your pay stub or direct deposit advice. Based on your salary level and the information you put on your Form W-4 (Employee’s Withholding Allowance Certificate) part of your pay is held back and remitted to the IRS. These payments held in reserve to settle up your tax liability (see below) when you file next April. Under the pay as you go system, each time you receive a paycheck, you pay a percentage of it to IRS.

EXAMPLE: $1,000 is withheld from your monthly paycheck. At the end of the year, $12,000 is available in an IRS income tax account under your social security number. That $12,000 is available to settle up your tax liability for the year.

So far so good?

II TAX LIABILITY

On or before April 15 of the following year, you (or I…) prepare your tax return and determine the amount of tax you actually owe. This number is completely independent of what you have paid in withholding as discussed above. If your tax liability is $10,000 (continuing our example) - you are due a refund (see below) of $2,000 after the IRS takes $10,000 of the $12,000 in your tax account balance.

III THE REFUND

If you paid in more in withholding than you owe in tax liability, you get a refund. Historically many more taxpayers have received refunds than not. The withholding tables are biased to slightly over-withhold on the theory that people will be much happier to get a few dollars back rather than paying a few dollars at the end of the year. So remember that the only reason you get a refund is because you’ve paid a little more than you owe. Right?

So when you get a refund at the end of the year it does not mean you are “paying less tax.” And if your withholding has not been sufficient during the year to settle your tax liability, you are not “paying more tax.”

You must pay the same amount of tax whether you get a refund or you owe. It’s just that when you get a refund, it means you’ve paid too much withholding.

Still confused? Who could blame you. Call me if I can help.