Your Refund is Not Your Tax Liability

Piece of paper that says "TAX" with hand holding pen
Photo by rawpixel on Unsplash

The Internal Revenue Service reports that so far this tax filing season, refunds are 9% down from last year. Reasons for this vary, but much of the change is attributed to the new tax law. Tax withholdings for federal taxes were reduced overall back in February 2018. If you didn’t do a “Paycheck Checkup” to compare your withholdings with your projected tax liability, the bottom line on your 2018 tax return could be a lot different than in the past.

Many taxpayers focus on whether they get a refund or owe more in taxes when it’s time to file. However, that is not the best indicator of your actual tax liability. Depending on a big refund to pay off bills or take a vacation also might not be the best way to manage your finances.

Think about it. Getting a tax refund means that you let the government use your money all year long before letting you have it. In other words, a refund is an interest-free loan to Uncle Sam. Does your bank lend you money for free? No! So why should you loan money to anyone – least of all the government – for free?

So how do you avoid making an interest-free loan or having to pay a lot at tax time? You’ve got to do two things – calculate your tax liability and withholdings, and compare the two amounts. Here are some tools to help you do it:

  • The IRS Withholding Calculator https://www.irs.gov/individuals/irs-withholding-calculator guides you through the steps to figure out your tax liability for 2019. Before using the calculator, make sure you understand how the IRS defines its terminology, know your pay frequency and note any life or work changes that impact your taxes (e.g., marital status).
  • If you owed additional tax for 2018, you may have to pay estimated tax for 2019. Estimated payments should be made if you expect to owe at least $1,000 in tax for 2019, and if you expect your total withholdings and refundable credits to be less than the smaller of 90% of your 2019 tax liability or 100% of your 2018 tax liability. More details are at https://www.irs.gov/pub/irs-pdf/f1040es.pdf

Your refund is not an indicator of your tax liability. Potentially, it’s an interest-free loan to the government that prevents you from using your own money. Doing a “Paycheck Checkup” get control over your taxes for next year and avoid making an interest-free loan or having to pay a lot next tax filing season.

How Americans Spend their Tax Refunds

The numbers are huge! Just a few days before the tax deadline, almost 120 million tax returns had been filed. More than 70% of those tax returns resulted in refunds back to the taxpayers totaling almost $243.6 billion. The average refund check or direct deposit amount was $2,831, slightly larger than last tax season.

 

So how do American’s spend their tax refunds?

 

GOBankingRates, a financial information and resources website, recently polled American taxpayers about how they planned to spend their tax refunds. The results were encouraging for money folks who preach fiscal responsibility. Here’s the full article. It’s an interesting read.

 

Per the survey, the five top ways that Americans spend their tax refunds are:

 

  1. Put into Savings – Forty-three percent of the survey respondents said they will put their refunds into savings. The survey was not specific about the type of savings. Let’s hope that savings includes an emergency fund for immediate needs and retirement contributions to meet long term goals.

 

  1. Pay Off Debt – Thirty-six percent said they will use the money to pay off debt. If that’s your situation, too, start by paying debt with the highest interest rate, like a credit card balance. More debt to pay after your refund is all used? Shift the amount you were paying on the paid-off balance to the next largest debt to get it paid off more quickly.

 

  1. Pay Toward a Vacation – Ten percent set aside their refund to pay for a vacation. Seems like a nice reward for getting through the year and filing that tax return. If your vacation funding choices are limited to putting it on a credit card or waiting for your tax refund, the refund “wins” every time – unless you can pay the card balance off each month.

 

  1. Splurge on a Luxury Item – Six percent go out and buy themselves a gift, whatever their heart desires. The bigger the refund, the bigger the splurge – jewelry, car, latest “bright, shiny object”. Let’s hope that these folks feel okay doing this because they already saved an emergency fund and maximized their retirement contributions.

 

  1. Necessary Major Purchase – Five percent need to use their refund for a major necessary purchase, like a home repair or appliance. Waiting to buy something you really need can be stressful, or even unsafe. Setting aside funds for emergencies and maintaining good credit are two ways taxpayers can avoid waiting for major purchases.

 

What about getting no refund?  The GOBankingRates survey found that 36 percent of those polled this year didn’t expect to receive a tax refund. Why is that a smart move? Well, you’ll have to check back and read my next blog to find out.