Analyzing Your Tax Returns Can Help You Avoid a Tax Refund Next Year
Your goal in filing your taxes should not be to get to a big tax refund. The reason why is a tax refund is a return of the money you overpaid in taxes all year long, money that you could have productively used. Rather than overpay, try to pay only enough taxes to meet your income tax obligation.
Most sophisticated financial planners will ask to see a client’s tax return to assess their financial situation. The reason is simple: your tax return is a complete summary of your financial holdings. By analyzing your tax returns, you can comfortably estimate your tax obligations in advance, withhold only what is needed, and ultimately avoid a tax refund.
Are you overpaying taxes?
If you received a refund, you have allowed the government to use your money for the year making it unavailable to you. In other words, you have given the government a 0% loan by overpaying your taxes each month. Remember, the term is a refund, which means, it is your money the government is returning to you.
A refund of $6,000 equates to overpaying taxes by $500 per month. You could have given yourself a $500 raise each month throughout the year by lowering your monthly tax payments (withholdings). The money could have gone toward paying down debt, investing for retirement or any other financial goal, or simply toward enjoying your life. Any of which would be preferable to giving it to the government to hold for you interest free.
How to Avoid a Tax Refund
Your goal in paying your taxes through your paycheck withholdings should be to withhold only what you need to pay your taxes and receive no tax refund. Fortunately, figuring out how much you should withhold is easier than you might think. If you did receive a refund, you can look at your tax return to estimate your tax liability for next year and then adjust your withholdings with your employer accordingly.
Step 1: Estimate Next Year’s Income
If you receive a W-2 each year detailing your income, you can use this year’s and previous returns to estimate your income for the upcoming year. Those without traditional employment, such as small business owners, independent contractors, self-employed, and those who are paid primarily in commissions, may wish to work with a professional financial advisor to estimate income.
If you have traditional employment income, you can use last year’s adjusted gross income (AGI) as a beginning point. Assuming you keep your 401(k) and other pre-tax contributions the same, your AGI number will be approximately the same this year as last.
If you are expecting a raise this year because you have gotten them consistently in the past, you can review previous years’ returns to identify if a consistent trend exists regarding a percentage increase in AGI. If so, increase next year’s AGI by the same percentage accordingly.
Similarly, those with other sources of income can use the past few returns to estimate this year’s income. For each source of income, identify if you will continue to receive the income. If so, estimate if the income will stay the same, increase, or decrease. Recent tax returns can again show you if a consistent trend exists.
Step 2: Estimate Deductions
Next, estimate the total tax deductions you expect for next year. You can easily predict if you will qualify for most deductible expenses again next year, such as dependent exemptions, professional expenses, scheduled charitable giving, and mortgage interest. For deductible expenses that you will incur again in the coming year, reduce next year’s income by this year’s deduction amount.
You can reduce certain deductions slightly, such as mortgage interest, if you expect to have less deductible expenses in the coming year. You can also ask your mortgage company what next year’s interest will be. If there are deduction amounts that you are unsure of for next year, leave them off your tax estimate. This will provide you a small cushion for deductions in case you have unexpected income.
If your deductions are difficult to estimate for the coming year, or you are unsure what qualifies for a deduction, a financial planner can help you estimate them more accurately.
Step 3: Determine Tax
Once you have your taxable income (AGI less deductions), you can estimate your taxes for the coming year using the IRS tax tables. The IRS usually publishes each year’s tax table around October of the previous year. The tax tables are surprisingly easy to use once you have determined your taxable income.
Take your estimated annual tax and divide it by the number of paychecks you receive throughout the year. This will give you the amount you want withheld from each paycheck to hit a $0 return.
For example, if you estimate $18,900 in taxes owed and receive a paycheck monthly, you would want $1,575 withheld from each paycheck (18,900/12). If you are paid bi-weekly, however, you would want $727 withheld from each paycheck (18,900/26).
Step 4: Adjust Withholdings
Now that you know exactly how much you will need to withhold for taxes from each paycheck, you then must update your employer with the amount to want withheld. Filling out a new form W-4 at work will allow you to adjust your withholdings to exactly the amount you want.
Although there is no place on the form to state exactly how much you want withheld, you have two tools to make the adjustment. The first is Line 5, “Allowances” and the second is Line 6, “Additional amount.”
The W-4 is simply a tool to help you withhold the appropriate amount of taxes, and you may use any number of allowances you want. Increasing your allowances will reduce the amount of tax withheld from your paycheck each pay period.
Your Human Resources or Payroll department easily should be able to tell you how much federal tax would be withheld from each paycheck based on how many allowances you claim. Keep increasing your allowances until you are withholding slightly less than what you want to withhold. For example, say you wanted to withhold $727. If 3 allowances withholds $743 but 4 allowances withholds $712, then enter 4 allowances.
Once you have the correct allowances, use line 6 (additional amount) to bring your withholdings up to the exact tax you wish withheld. In our example, you need to withhold an additional $15 per pay period to withhold a total of $727 ($712 from 4 allowances plus $15 additional withholdings). At this rate you will increase your monthly take-home pay, hit $18,900 in taxes withheld for the year, and receive no tax refund.
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Joshua Escalante Troesh is a tenured professor of Business at El Camino College and the founder of Purposeful Finance. His career provides him with a unique insight on personal financial, having been a VP at a financial institution leading up to 2008, and involved with technology and internet stock research leading up to 2000. He can be reached for comment at info@purposefulfinance.org