A tax refund is a reimbursement to taxpayers who have overpaid their taxes, often due to having employers withhold too much from paychecks. The U.S. Treasury estimates that nearly three-fourths of taxpayers are over-withheld, resulting in a tax refund for millions. Overpaying taxes can be viewed as an interest-free loan to the government. On the other hand, approximately one-fifth of taxpayers underwithhold; this can occur if a person works multiple jobs and does not appropriately adjust their W-4 to account for additional income, or if spousal income is not appropriately accounted for on W-4s.
Why Do I Get a Tax Refund?
Most employers are required to withhold income taxes each time they pay their employees. When the total amount withheld from an employee’s paycheck throughout the year exceeds the amount they actually owe in taxes, the result is a tax refund.
The amount that employers take out of each paycheck and send to the Internal Revenue Service (IRS) is based on withholding tables, which instruct employers on how much tax to withhold from an employee’s paycheck.
Employees contribute to this process by filling out the form W-4, where they account for their filing status, dependents, tax deductions, and other details that can affect their tax burden. The amount of taxes withheld varies based on paycheck frequency, the W-4 form, and salary. Employees also can fine-tune how much to withhold in projecting what their year-end liability will be.
This leads to three possible outcomes when filing taxes:
- Accurate withholding—the amount withheld from the employee’s paychecks matches the amount they owe in taxes, so they do not receive a refund or owe taxes when they file.
- Underwithholding—the amount withheld from the employee’s paychecks was not enough to pay the amount they owe in taxes, so they have a balance due when they file. That potentially can led to penalties for underpayment, depending on the amount owed.
- Overwithholding—the amount withheld from the employee’s paychecks exceeds the amount they owe in taxes, so they receive a refund (without interest) when they file.
Don’t Judge Your Tax Burden by Your Tax Refund
Regardless of whether an individual overwithholds or underwithholds, receiving a tax refund or owing the IRS come tax time does not tell you how much you paid in taxes and is not the best way to evaluate your income tax burden.
Instead, taxpayers can look at their Form 1040 to see how much total income tax was paid and compare that amount to how much they earned in the year to determine their effective income tax rate.
If an individual wants a more accurate withholding, they can use the IRS Tax Withholding Estimator tool and update their form W-4 with their employer.
Overpaying Your Taxes: An Interest-free Loan to the Government?
A large tax refund can feel good, and some taxpayers even treat them as a savings vehicle, but taxpayers would be better off not overpaying their taxes in the first place.
In effect, overpaying your taxes is the same as offering the government an interest-free loan.
Rather than looking forward to a tax refund, taxpayers should adjust their withholding to accurately reflect the taxes they owe and instead invest the amount that they would otherwise be refunded in interest-yielding savings accounts or investment accounts like a 401(k).
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