How Tax Withholding Affects Your Tax Refund

Daniel Ruske |
Categories

Every year, around March and April, we begin to hear people talk about the big plans they have to spend their anticipated tax refund. Some plan vacations to various destinations around the world, others plan to pay off debt, or add to their savings. All too often, this anticipated windfall turns into an unwelcomed tax bill to the IRS. 

We have found that many individuals may not know what goes into calculating their yearly income taxes and why they may or may not get a tax refund. This article will serve as a simple reminder of the fundamental components that determine your tax refund.

What are Tax Refunds?

Tax refunds are not gifts from the government that you receive for filing your taxes. They are a return of your dollars that you have overpaid in taxes during the year. In most cases, when you receive some form of taxable income whether it be from a pension, Social Security, or a distribution from a retirement account, a portion of your payment goes directly to the IRS, or toward paying your state income taxes. This is known as withholding. You, the taxpayer, controls how much of your payment goes towards paying the IRS and the state. Due to tax deductions, tax credits, or a miscalculation, a household may over or under withhold the required yearly income tax they owe. An over payment of taxes will result in a tax refund, and an under payment will result in owing a tax liability. So, you, not the IRS or your state government, decide whether you get a refund each year because you determine how much is withheld from each paycheck.

The amount of your tax refund or liability received at the end of the year is not a good indication of your total yearly income tax liability. For example, a large refund does not mean your taxes are low, and having to write a check to pay state and federal tax does not mean your taxes are high. Receiving a refund or paying a liability is a reconciling of the income tax dollars you are required to pay. 

Tax Withholding

Tax withholding can be adjusted on income from Social Security, pensions, distributions from IRAs, and salaries. You can also make an estimated quarterly payment directly from your checking account. So, if a person is looking for a large tax refund, they should increase the amount of taxes that are withheld throughout the year and the IRS will return it to them in the form of a refund.

Does it Matter if I Over-withhold or Under-withhold?

In most cases, the goal is to withhold taxes in the amount that will result in as small of a refund, or tax liability as possible. However, incomes, salaries, and laws can all change throughout the year making it difficult to achieve the goal of a net zero tax refund or tax liability. So, is it better to overpay taxes during the year and get a refund? The answer… it depends. It comes down to preference. Individuals who prefer to receive a tax refund check during tax season should look to over-withhold. Individuals who prefer to have extra cash throughout the year, even if that means paying a tax bill come tax time may prefer to under-withhold.

There are two extremes that help explain the concept of withholding and tax refunds.

  • Under-withholding: A couple has a taxable income of $81,050 in 2022 and withholds nothing. Their paychecks will be higher throughout the year, but when they file their taxes, assuming no penalty applies, they will owe a federal tax bill of $9,315.
  • Over-withholding: A couple has the same taxable income of $81,050 in 2022 and withholds $14,315. Their paychecks throughout the year will be lower since a higher portion is going to tax withholding. Instead of owing $9,315 at the end of the year, they will receive a refund of $5,000 because they over withheld.

It is important to understand that, assuming no under-withholding penalty applies, over or under-withholding taxes throughout the year does not result in a larger or smaller total tax liability. The only difference is the timing of when the taxes are paid. 

When do Underpayment Penalties Apply?

You may be thinking, “Well if the timing of my tax payments doesn’t impact the amount of total tax I pay, then I won’t withhold anything all year and invest the tax payments in a high yield investment account. I can then pay my full tax bill at the end of the year and keep the interest I earn.” This can be a reasonable strategy assuming two things. First, you don’t lose money in your investment over the course of the year, and second, you don’t pay more in underpayment penalties than you make in interest. In most cases, you can avoid an under-withholding penalty if you withhold at least 90% of the tax due for the current year, or if you withhold 100% of the previous year’s tax liability. 

You Owe What You Owe

Whether you are looking for a tax refund, or you prefer to not give the government an interest free loan and plan on paying your tax liability every April, you can rest assured knowing that as long as you satisfy the minimum withholding requirements, your total tax obligation will be the same.