Is Getting an IRS Refund Good?The short answer to the question above is “no”. You might think I am crazy after reading that, but hear me out. Giving the government money that they will pay you back is like giving your local bank an interest free loan. They get to use the extra money (that they are not owed) on whatever they want. They might invest your money and earn interest on it. When you give them back the principal, they’ve already earned money on it. Instead of the government wheeling and dealing with your money, you could be using it to accomplish your goals. Like paying down your student loans or investing in a backdoor Roth IRA for the first time in order to achieve financial independence. Some may argue that getting a refund is a “forced way” to save money. In other words, they are arguing that the refund helps them save money that they would otherwise spend. If you need the IRS to save money for you, then we have bigger problems to address. My first suggestion would be for you to check out the questions that can help you figure out your “why” behind your money decisions. After you do that, you should gain the motivation necessary to learn how to make smart financial decisions on your own – without needing the government to help you out.
Why Are People Getting an IRS refund from Their Tax Return?The Tax Cuts and Jobs Act changed a number of things that might lead to people getting a larger IRS refund. Particularly those reading this site. Reason Number 1: The new tax brackets favor high income earners. Particularly if you have kids and get the tax-credit (AGI < $400,000 if married). The standard deductions are also more substantial. Reason Number 2: The AMT is unlikely to hit you this year for a variety of reasons. (Check out the linked post if you want to know why). This can result in a big IRS refund if you paid the same amount of taxes as you did before the new tax bill. Of course, this assumes you don’t live in a high tax state where your benefit from the State And Local Tax (SALT) deduction is now much more limited ($10,000 max).
Why Should I Avoid an IRS Refund? A Case StudyWe’ve answered why getting an IRS refund on your tax return is a bad idea. To drive home the point, let’s look through an example. Let’s say that instead of letting the government make interest off of the money you gave them, you used it for your own goals. In this example, let’s say that you get a $10,000 refund from the IRS. How much interest has this cost you, if you had used that money towards your student loans instead? Assume your debt is at a 5% rate, the answer is $500. What if you decided to invest it instead? If you put that $10,000 into the market instead and it earned 8% interest. Your original $10,000 loan to the IRS would turn into $10,800. Then, they would turn around and only pay you back the original $10,000. Seems like a bad deal.
How do you determine the total number of allowances you are claiming?Figuring out the total number of allowances you are claiming (or should claim) can be challenging. Fortunately, there are tools to help us do just that!
If you want to know specifically what goes into this calculation, you can check out the W-4 worksheet (page 3) found here.The W-4 worksheet linked above takes into account your income, number of dependents, whether you are married, taxes, and income(s). The easier way to do this is to use this calculator from the IRS. In order to determine the total number of allowances you are claiming using the W-4 calculator, you will need your last pay stub (and your spouse’s, if married) to see how much has been taken out. The calculator takes this into account to determine if you are on track or not. Once the data is placed into the calculator, it will determine if you need to make any changes to your W-4 allowances. It will then also tell you how many allowances you should adjust to so that you don’t over or under pay significantly. Remember, if you are going to miss it is better to pay the government in the end than to get a check back from an interest free loan to the government. When I filled out my information, it told me that I needed to be taking 8 allowances and I was currently taking 4 allowances.
How much does each W-4 allowance change my pay check?The answer is that it depends. I increased my allowances from 4 to 8 because of the above calculator during 2018. This increased my annual take home by $5,312 and my monthly take home pay by $443. Could I have known that before I saw my next take home paycheck? The amount that each allowance increases your paycheck depends on your filing status and income. The following tables come from TurboTax (which took them from the official IRS publication). I thought the Turbotax tables were more reader friendly. Table A shows you what your annual increase would be. The next table (Table B) shows you the change in your monthly income with each allowance.
Table A: Annual Change
|Annual Income for Single Filer||Annual Income for Married Filing Jointly||Value of Each Withholding Allowance (Annual)*|
|Up to $13,225||Up to $30,600||$415|
|$13,226 to $42,400||$30,601 to $88,950||$498|
|$42,401 to $86,200||$88,951 to $176,550||$913|
|$86,201 to $161,200||$176,551 to $326,550||$996|
|$161,201 to $203,700||$326,551 to $411,550||$1,328|
|$203,701 to $503,700||$411,551 to $611,550||$1,452.50|
|Over $503,700||Over $611,550||$1,535.50|
Table B: Monthly Change
|Annual Income for Single Filer||Annual Income for Married Filing Jointly||Monthly Value of Each Withholding Allowance**|
|Up to $13,225||Up to $30,600||$34.58|
|$13,226 to $42,400||$30,601 to $88,950||$41.50|
|$42,401 to $86,200||$88,951 to $176,550||$76.08|
|$86,201 to $161,200||$176,551 to $326,550||$83|
|$161,201 to $203,700||$326,551 to $411,550||$110.67|
|$203,701 to $503,700||$411,551 to $611,550||$121.04|
|Over $503,700||Over $611,550||$127.96|
Will I get fined for not paying enough taxes?People always get antsy because they don’t want to “pay too little and get fined.” Let’s talk about it. You can avoid the fine if you do any of the following according to the IRS:
- Owe less than $1,000 in tax after subtracting with-holdings and refundable credits.
- If you pay withholding and estimated tax within 90% of this current year’s taxes. (For example, you owed $100,000 in taxes; and paid $90,000).
- If you paid 100% of the tax you owed on last year’s tax return (actually NOT true here for high-income earners... it’s 110% if you earn more than $150,000).
How to make sure you don’t get hit with the fineAs you can see from Number 1 and Number 2, “good enough” math is the goal. You need to be within 90% of what you were supposed to owe and withhold that from your payments. OR… number 3 allows to pay 110% of last year’s taxes. This is beneficial if you, like me, just finished training because you definitely paid less tax last year. The take home point is to pay 110% of what you paid during training and you won’t get hit with the fine. Of course, if you weren’t in training for half of the last year, then this is a terrible method. Given that you are likely to pay a LOT less tax this year than last (unless you in a high-tax state impacted by SALT limitations). So, paying 110% of last year’s tax will just result in you giving the government an interest free loan and getting an IRS refund, which is exactly what we are trying to avoid. My advice? Check half way through the year and then again in September to make sure you are on track to be within 90% or $1,000 of this current year’s estimated taxes. If you do this, you won’t get fined by the IRS.
What is the fine if I make a mistake?For 2019, you owe the taxes back + 4% interest. So, if you missed by $2,000 then you owe $80. That’s not too bad. I should mention that the fine starts earning interest from the quarter in which you should have owed the taxes. So, if you owe quarterly estimated taxes (keep reading, if you aren’t sure), this number could grow. That said, it’s not that steep of a fine unless you royally screw up the math and you are off by tens of thousands. Don’t do that.
What if the IRS thinks you intentionally withheld too much?The reason you shouldn’t do that is because if the IRS determines that you intentionally falsified your W-4 allowances or quarterly payments if self-employed, the penalty can be steep (see below). This is why I always recommend you use the IRS calculator to determine your allowances. How steep can the penalty be? It can cost you $500 and be considered a crime.
I’ll copy this one straight from the IRS website (Pub 505):
[A tax payer] may have to pay a penalty of $500 if both of the following apply.There is also a criminal penalty for willfully supplying false or fraudulent information on your Form W-4 or for willfully failing to supply information that would increase the amount withheld. The penalty upon conviction can be either a fine of up to $1,000 or imprisonment for up to 1 year, or both. These penalties will apply if you deliberately and knowingly falsify your Form W-4 in an attempt to reduce or eliminate the proper withholding of taxes. A simple error or an honest mistake won’t result in one of these penalties. For example, a person who has tried to figure the number of withholding allowances correctly, but claims seven when the proper number is six, won’t be charged a Form W-4 penalty. However, see chapter 4 for information on the penalty for underpaying your tax.
- You make statements or claim withholding allowances on your Form W-4 that reduce the amount of tax withheld.
- You have no reasonable basis for those statements or allowances at the time you prepare your Form W-4.
I am self-employed – Should I make quarterly estimated payments?People who should consider making estimated quarterly payments (and are often required to by the government):
- “Individuals, including sole proprietors, partners, and S corporation shareholders, generally have to make estimated tax payments if they expect to owe tax of $1,000 or more when their return is filed.”
- You get paid money that does not have taxes withheld (i.e. 1099 income, large dividend income, etc) and you expect to pay more than $1,000 in taxes.
Use an IRS calculator to figure it outThe simple answer is that if you earn more than $150,000 in a year, you may need to pay quarterly estimated payments. Here is a tool provided by the IRS to determine if you should or not. Feel free to use that tool to determine the specifics of your situation. BUT… do the math to make sure you aren’t overpaying! Remember, the goal is to not provide an interest free loan to the government. It’s the same for both the employed and self-employed.
Take Home?The simplest way to figure out the total number of allowances you are claiming is to use the IRS’ own W-4 calculator and tools. I think that if you use their own device, it would be hard to say that you were intentionally doing the wrong thing. Here’s the key takeaway: to avoid the problem of giving the government an interest free loan, you probably ought to check your W-4 allowances two or three times during the year to make sure you are on track Use the calculators to stay on track. Add up the math to see what the difference might be.
What do you think? Do you make multiple W-4 adjustments or quarterly estimated payments to make sure you aren’t paying the government too much? Have you ever had issues with any of this? Leave a comment below.TPP