During this time of year, Americans usually fall into one of two camps. Either they are excited because they are expecting a big tax refund or sad because they know they will end up going. No matter what camp you fall into, I want to explain why neither scenario is ideal and some tips to keep in mind before next tax season.
How Do Taxes Work?
First, it may help if I explain how income taxes work. Every working adult is subject to federal and state income taxes. If you live in certain states like Florida, Texas, or Washington, there is no state income tax and you are just liable for federal taxes. It may help to think of the government as a corporation. Income tax is its greatest source of revenue. It uses those taxes to fund infrastructure projects, medicaid, medicare, food stamps, etc.
When you are hired at a company, one of the first forms you fill out is a W4. This tells your employer how much federal income tax to take out of each check. The number you put in the box is your exemptions. Exemptions lower the amount of taxes taken out of each check but be careful! Too many and will owe Uncle Sam at tax time. Too little and you will have a big refund. As a Human Resources professional, if I had $1 for everyone employee that put 0 or 1 in the box for exemptions without calculating how many exemptions they really need, I would be rich! Big mistake!
What's Wrong With a Big Refund?
If you receive a big refund at tax time, that means you overpaid the government throughout the year and now they have to give some of that money back to you, hence the term "tax refund". This is not good because you are essentially letting the government borrow your money at no interest and no return on investment. If you adjusted your exemptions to get closer to not having a refund, you could do a lot more with your money throughout the year. Even letting the money sit in a low interest rate savings account be better than overpaying the government!
How Do I Know How Many Exemptions to Take?
Of course, I recommend talking to your tax professional but the W4 form has a worksheet at the top of the page to give you a good starting point. If you answer the questions accurately, you should not have to worry about owing! Due to my current tax situation, I claim 9 exemptions so I barely pay federal income tax throughout the year and still end up not owing Uncle Sam.
You have the ability to change your withholdings throughout the year so my homework for you is to use this tax season to see where you need to make adjustments. Reevaluate the W4 form that you filled out when you first started your current job. If you end up with a huge refund, try raising your exemptions.If you end up owing the government, try lowering your exemptions. Also, anytime your tax situation changes, for instance you get married or have a baby, do yourself a favor and reevaluate then too. You can thank me later!