Monday, 26 October 2020

Don’t Use Your Tax Refund as Forced Savings

Don’t Use Your Tax Refund as Forced Savings
26 Apr
10:59

Getting a fat tax refund from the IRS may put a big smile on your face. But before you get too excited, heed the words of hip-hop legend the Notorious B.I.G.: mo’ money, mo’ problems.

A big refund check isn’t a sign you’re getting free money from Uncle Sam—in fact, quite the opposite. It means that throughout the year, you’ve granted the government an interest-free loan from your paycheck, and now you’re getting the principal back in one lump sum. You’re not making any more money than if you had taken that cash, buried it in your yard and dug it up in April. Thankfully, there’s a better way.

Don’t use the IRS as a forced savings account

Most Americans only think about their federal income tax once a year, ahead of the April 15 tax deadline. But it’s important to understand that you’re paying income taxes with every pay period. For workers receiving wages, state and federal income tax is withheld by employers with each paycheck (It gets even more complicated if you’re self-employed or a freelancer; you’ll usually have to pay an estimated quarterly tax).

Your employer calculates how much of your paycheck to withhold, ensuring you pay your annual tax bill over time, based on the information you filled out on your W-4 when you start a job. Many people fill out the form without a second thought, but it has an impact on your financial life because it determines the size of your withholding.

On your W-4, you claim a certain number of tax allowances. The more allowances you claim, the less money is withheld from your paycheck. The general rule is that you can claim one allowance for the following:

  • Yourself
  • Your spouse
  • Any dependents you can claim (this will usually be your children, but can be anyone who qualifies under IRS rules)

This list above provides a good baseline for claiming allowances, but maxing out your claims isn’t as simple as taking a tally of everyone at the dinner table.

Claim the right amount of allowances to avoid overpaying

When claiming allowances on your W-4, your goal should be to land on the amount that matches your federal tax liability—how much you owe the government in taxes—as closely as possible. If you do it right, your tax liability should be divvied up precisely and paid off via withholding in each pay period. Get it right, and you won’t receive a tax refund.

How do you determine the correct amount of allowances to claim to avoid the ritual of forced savings and refund checks? The IRS provides personal worksheets with the W-4 form that can help you calculate the maximum amount of allowances you’re entitled to.

Answer the following questions in order to figure out how many allowances you should claim.

Should I claim the Child Tax Credit?

As alluded to earlier, claiming just one allowance for each of your children may mean you aren’t taking all the allowances you could. If you’re claiming a tax credit for each child, the number of allowances you claim for each child depends on your total income, and if you’re filing as a single person or married filing jointly.

Filing Single Married Filing Jointly Number of Allowances Per Child
Less than $71,201 Less than $103,351

4

$71,201 to $179,050 $103,351 to $345,850

2

$179,051 to $200,000 $345,851 to $400,000

1

Higher than $200,000 Higher than $400,000

0

You should also take into account tax credits you will claim for eligible dependents who aren’t your children, which affects the number of allowances you can claim.

Filing Single Married Filing Jointly Number of Allowances Per Child
Less than $71,201 Less than $103,351

1

$71,201 to $179,050 $103,351 to $345,850 1 for every 2 dependents ( if you only had one dependent, you would claim 0 allowances. If you had 2 dependents, you would claim 1 allowance)
Higher than $179,050 Higher than $345,850

0

Do I have more than one job? Does my spouse work?

If you’ve fully embraced the cult of the side hustle — willingly or not — or if your spouse also works, and the combined income from all of these jobs exceeds $53,000, you may want to claim additional allowances. The Two Earners/Multiple Jobs worksheet that comes with the W-4 walks you through the many allowances you could claim, but in general the number of allowances you can claim is based on the wages you earn from your lowest-paying job.

Am I claiming itemized deductions?

The Tax Cuts and Jobs Act passed by Congress and signed into law by President Trump at the end of 2017 changed the calculus for many taxpayers who normally devote hours to claiming itemized deductions. “There will be a lot of disconnect this year for people who have relied on itemized deductions that are no longer deductible,” said Michael Goldfine, CPA based out of New York, NY.

The changes to the tax code in 2017 nearly doubled the standard deduction, from $6,350 to $12,000 for single filers (and from $12,700 to $24,000 for married couples filing jointly). This means it usually makes more financial sense to simply claim the standard deduction. If you do that, you wouldn’t claim an additional allowance on your W-4.

However, if you believe the value of itemized deductions you can claim exceeds what you would get with the standard deduction, then the amount greater than the standard deduction figures in to whether or not you should take another allowance.

What other deductions or adjustments should I claim?

You’ll also want to think long and hard about any income you’ve earned that’s not from wages and isn’t subject to federal withholding. Interest earned from bank accounts or dividend payments from stocks, for example, could all contribute to how many allowances you can claim. By filling out the Deductions, Adjustments and Additional Income worksheet with Form W-4, you can estimate the number of allowances this income entitles you to claim.

Don’t claim more allowances than you’re owed

While withholding too much and not claiming as many allowances as your circumstances allow gives the federal government an interest free loan, the opposite — claiming too many allowances and not withholding enough — isn’t ideal either.

If your employer doesn’t withhold enough money from your wages, you can expect to receive a bill instead of a refund check. And if you owe the government more than $1,000, you may also have to pay a penalty fee (which the IRS will happily calculate for you). This is especially true if this isn’t the first time you’ve come up short with Uncle Sam.

“If you owed money last year, and you owe money again this year, you’re going to get underpayment penalties,” said George Dimov, CPA at Dimov Tax Associates in New York City. “That applies to the IRS and to the states. In that case, if you don’t want a penalty, you should overpay.”

The amount the IRS will charge you varies on your individual circumstances, but according to Dimov it’s generally 2% to 3% of the amount you still owe the government — “the IRS has its own proprietary formula to estimate [the penalty],” he added.

In general, you won’t have to pay a penalty if:

  • The amount you owe the IRS is less than $1,000
  • You’ve paid 90% of your tax liability (the IRS lowered this threshold to 80% for the 2018 tax year only to take into consideration how changes to the tax law could confuse tax filers)
  • You paid 100% of your tax liability in the previous tax year

While the fact that you have $1,000 of leeway before incurring an underpayment penalty may tempt you to err on the side of claiming more allowances than you’re strictly entitled, keep in mind one allowance generally equals $4,200. The best way to avoid claiming too many allowances is to only claim those the IRS says you can, per the worksheets included with form W-4.

How Americans are spending their forced savings

Now that you know how to dial in the proper amount of allowances to claim and no longer give the federal government more money than it’s owed throughout the year, you can start putting your income to better use.

The average size of a tax refund so far for 2018 filings is $2,873. According to a National Retail Federation survey of tax filers, 49% of those expecting a refund this year plan on putting that refund money into some sort of savings account or product.

That’s great, except they’ve already lost out on a year’s worth of interest because of overpaying Uncle Sam with each paycheck. If they had claimed more allowances and placed the extra money from their paycheck into a common savings product, here’s how much they would have earned via interest.

  1-Year CD Savings Account Tax Refund
Interest Earned 1.373%* 0.272%* 0
Money earned after a year $39.72 $7.83 $0

*APY for the 1-year CD and savings account are both based on national averages according to data from DepositAccounts.com as of April 2019; MagnifyMoney and DepositAccounts.com are both owned by LendingTree. Money earned after a year calculated assuming a deposit of $2,873 into either product.

Granted, the money earned from either a CD or a savings account won’t bump you into a higher tax bracket, but think of it this way — would you put your money in an account that offered zero interest? Because that’s what you’re doing when you don’t claim the proper amount of allowances on your W-4 and let the government hold on to your hard-earned cash for a year before paying it back in a big refund check.

The bottom line on your tax refund

Telling people they should feel bad about receiving a big tax refund ranks just above telling children Santa is a lie. And just like believing in Santa, getting a refund check for thousands of dollars might just give some people a warm, fuzzy feeling that justifies the cost.

However, the view through the cold, calculating eyes of a personal finance expert suggests that getting a large tax refund is a lost opportunity to invest money where it earns interest, such as a savings account or CD. You have to decide whether the excitement of that tax refund is worth the money you’re losing out on.

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James Ellis
James Ellis |

James Ellis is a writer at MagnifyMoney. You can email James here

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Source: https://www.magnifymoney.com/blog/tax/do-not-use-tax-refund-as-forced-savings/

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