Tax Refund or Payment: What Side Do You Fall?
Taxes are one of those things that you have to do. You are legally required to pay taxes every year. If you do not pay taxes, you could be heavily penalized or even sent to prison. It is important that you make sure you pay your taxes to avoid those two things. While we all know that we have to pay taxes, many of us do not understand how taxes work. We just hope for the best each year when we file taxes.
Many of us hope for the biggest tax refund we can get. I even know some people that intend to use their tax refund for a large purchase like vacation or a car. The downside to that is getting a tax refund is not always the best financial decision.
Many economists believe that the best way to handle taxes is to break even, or even owe money at the end of the year. Continue reading to find out more information about taxes and the best tax refund.
What Are Tax Deductions?
A tax deduction is an item that the IRS allows you to deduct from your taxes. This item has a dollar amount associated with it. You are able to deduct this amount from your Adjusted Gross Income (AGI) and it makes the amount of money on which you owe taxes lower. The lower your taxable income is means the lower amount of taxes you must pay. This could mean a higher tax refund. A typical deduction is mortgage interest deduction.
Tax Credit
There is also something called a tax credit. A tax credit is an actual reduction to what you own in taxes. A common credit is the child credit. This is a credit of $2,000 per child. Let me give you an example with numbers to highlight the difference.
Please keep in mind these are not actual numbers, they are just for the purpose of this example.
Here is an example of a tax deduction
You earn $50,000. You have a $2,000 deduction for mortgage interest. This is how the numbers work:
$50,000 (earnings) - $2,000 (mortgage deduction) = $48,000. Your tax rate is 20 percent, which means you owe $9,600 in taxes.
Let me show you an example with the same numbers, but with a child credit instead of a deduction.
You earn $50,000 and you have 20 percent in taxes = $10,000. $10,000 (taxes) - $2,000 (child credit) = $8,000 in taxes.
What Can I Deduct?
I mentioned this a bit earlier, but want to mention it again. A deduction is not the same as a credit. A deduction and a credit are not the same as lowering your tax liability, also known as your taxable income. For now, I want to address deductions and what you can deduct from your taxes, which could increase your tax refund.
Charity
If you make a cash donation, you need a receipt. If you make a non cash donation over $500, there is an additional form you must fill out.
Interest From Your Mortgage
You can deduct interest that you pay. You cannot deduct the principal you pay. It must be your primary residence. If you purchased your home after December 2017, you can only deduct up to $750,000 in interest.
Student Loan
You can deduct up to $2,500 in interest from student loans. You do not need to itemize your taxes to get this deduction.
Medical
You can deduct medical expenses, including dental, that you pay out of pocket as long as it exceeds a specific percentage of your income.
What Am I Not Able To Deduct?
There are many things that you cannot deduct. Some of them you probably think you should be able to deduct, but you cannot.
They are items like commuting costs, unless it is considered a business expense. If these are ordinary commuting costs, you cannot deduct them.
Home improvements also cannot be used as a deduction, unless they make your house more energy efficient. They may, however, increase the value of your home.
Child support payments and gym costs are also not qualifying deductions.
The cost of pet care expenses are also not tax deductible.
None of these items will be able to get you a higher tax refund.
Other Ways To Decrease My Taxable Income
There are other ways to decrease your taxable income and potentially increase your tax refund. Some additional ways to reduce your income are to invest the most money you can into your 401k or IRA accounts. These accounts are pre tax so the money comes out before your income is considered taxable. This decreases the amount of your taxable income.
If your employer offers a health savings account (HSA), you should invest money in that. This money also comes out of your check before taxes, so it decreases your taxable income. You can use this money for co pays and other medical expenses, so it is a win win. You can contribute to a 529 account for your children. This money is not a federal deduction, so it will not reduce your federal taxable income, but some states will allow it as a state deduction.
What Is The Standard Deduction?
Anyone that has ever done his or her own taxes has some idea of the standard deduction. There are two ways you can get deductions on your income tax returns. You can choose the standard deduction, or you can itemize them. You are not able to do both. Most people try to do their taxes both ways to see what gives them a higher deduction. Most people quickly find out that they do not have enough separate deductions for them to itemize and they opt for the standard deduction.
If you are using a product to help you do your taxes for yourself, it informs you if you are better off using the standard or itemized deductions. This is one of the tax tools you can use for your income tax filing. Using the deduction method that gives you a higher deduction impacts your tax refund.
How much is Standard Deduction?
The 2022 standard deduction is $12,950 for single filers and those married filing separately, $25,900 for joint filers, and $19,400 for heads of household.
Is It Better To Get A Refund?
This is a question that a lot of people ask. In reality, it comes down to your individual situation as to whether it is better for you to get a tax refund or make a tax payment. Many financial advisors and economist say that it is better to owe money at the end of the year then to get it back. They go on to say that if you are going to get a tax refund, it should be a minimal one. Ideally, it is best to break even and own nothing and get nothing in return. I have found that it is really difficult to do.
You Are ‘Loaning’ Government Money through Paying Taxes
Here is the easiest way for you to think about it...any more that you get back from the IRS after you do your taxes is your own money that you have given to them throughout the year. It is money they were able to hold onto and from which they made interest. You essentially loaned money to the government and you did not even make any interest on it. Thinking about it the other way around, if you owe money to the government at the end of the year, it is basically money that you borrow from them, interest free throughout the year.
How to Use Refund Money?
If you get money back at the end of the year, you could change your withholding and have a little more money in each pay check so that you do not get as much back when you file your taxes. This is money that you could use each month to pay bills, or put in a savings account that draws interest.
You must be careful, though, because it can easily go from you getting money back to you owing money when you file your taxes. However, even if you owe a little bit of money, most financial advisors tell you that is a better way to go.
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How Much Should I Withhold?
So, this just leads up to how much money should you have withheld so that you do not get a huge tax refund when you file your taxes.
W4 Form
A W 4 is the form where you select how much is withheld from your paycheck. It is a bit of a guessing game, however there are some worksheets that can help you determine the best withholding amount for you. Basically, there is a number you select that is your withholding amount. The larger that number, the less that is withheld from your paycheck.
Listing Your Allowances
This number is the amount of allowances that you claim. This is telling the IRS that you have other responsibilities, such as a house, a spouse, or children. As a result of those responsibilities, you should have less withheld from your check. This often means that you might end up owing money when you file taxes, depending on your allowances. Remember, the higher the number of allowances means the less taxes withheld each paycheck, which means you may not pay enough taxes throughout the year.
Most people claim from 0 to 4 allowances. Claiming 0 means the maximum amount of taxes that can be withheld from your paycheck is withheld. Usually, 0 is not the recommended choice for allowances, unless you really want to get a nice refund at the end of the year. I would recommend that you start with a withholding of 1 and see how that impacts you when you pay your taxes.
If you really want to try to get close to break even and you do not have children, you could claim 2 and see how that impacts you. Just remember, you may have to pay a small amount of money.
What Is Income Tax?
You probably know by now that the tax laws in the US are not easy to understand. They also seem to change quickly. Many of us can do our own income taxes every year, but we may be missing out on some serious savings. For me personally, I do not want to attempt to understand all the tax law changes, so I choose to pay someone else to do that. That may not be the right decision for you. The best way for you to make the right decision is to have a better understanding of tax terminology.
Income tax is a tax, or fee, that you have to pay on the income you earn every year. There are income taxes charged to you at a federal level and at the state level. There are a handful of states, Florida, Alaska, Nevada, and Washington, that do not have a state income tax. They choose to have higher taxes for sales, property, and excise. The percentage of tax that you pay depends on your income bracket. Typically, the higher your income, the more higher percentage you pay.
IRS sets an amount that requires you to file a tax return. So, if you earn under that limit, you do not have to file a return. That does not mean you do not have to pay income taxes. Your income is still taxed with every paycheck. You can lower the amount you are taxed by making use of tax credits and deductions. Your deductions and credit can impact that amount you receive as a tax refund.
Are There Other Taxes I Have to Pay?
It sure seems as though there is always some type of tax that you have to pay. It would be nice if income tax was the only one, but it is not. Some, but not all, of these taxes can be claimed on your income tax return and have an impact on your tax refund.
I am going to list a few of the common ones here for you:
Sales Tax
This may be referred to as a consumption tax. This is a tax added on to the money you spend on items. The more you consume, the more you pay in taxes. This is a percentage of the sales price. Each state sets their own sales tax and Delaware does not have a sales tax. Unless you can shop in Delaware, it is almost impossible to avoid sales tax.
Estate Tax
This is a tax you incur when someone passes away and you are an heir to the estate. This tax is based on the net worth of the estate. If you have been left an asset by someone that has passed away, you should contact an estate tax professional to help you with your taxes. This person can also help you set up a structure to ensure you have the least amount of taxes possible.
Property Tax
This is a tax that you pay on your house, land, and any other real estate. The money from these taxes go to improving schools, roads, and sewers in the general area of the property in which you pay taxes. Property tax changes based on the state in which the property is located. Before you purchase property, remember you will also have to pay property tax, so you should make sure that you can afford the tax. You can claim property tax on your tax return.
Excise Tax
This is a tax of specific items that we purchase. Some items that fall under this category are alcohol and tobacco. Some times this tax is referred to as a sin tax. The only way to avoid paying this tax is not buy these items. Typically when you see the price of the item at a store, it already has the tax added.
I See Different Taxes Listed On My Paycheck; What Are They?
I remember when I got my first job and I was so excited to get my first paycheck. That is until I opened it. I have never been deflated so quickly in my life as I was when I saw how much money I actually brought home. I saw a lot of numbers that were subtracted from my check, but I really did not understand why. That is when I had my first lesson in gross versus net income. I was not happy. I would imagine many of you had a similar experience.
I knew taxes would be taken from my check. I just did not realize how much of an impact it would be on my take home. For those of you who still do not know what all those subtractions are, I am going to tell you.
Gross and Net Income
The number of how much money you earn before any deductions at all is called your gross income. Never get used to that number because you will not see it in your bank account. If you do, that means no taxes were withheld and then you have another problem. The amount of money that actually gets deposited into your bank account is your net income. This is what you make after all deductions.
Year to Date Deductions
Now, let us talk about all of those deductions. Your pay stub may show year to date deductions and the deductions just for that specific check. Obviously, the higher number is the year to date deductions. The year to date shows all of the deductions from all of your paychecks since the beginning of this calendar year. When it is a new calendar year, it all starts at zero again.
Various Withheld Taxes
You should see a line item for OASDI. This is your Social Security tax. You also see a line item for FICA, or Medicare, taxes. Then you will see another line item for federal taxes that are withheld. These taxes are different from the ones for OASDI and FICA. You must pay all of them. In addition, you also see state taxes withheld. These are taxes that are withheld from the state in which you work. If you work in a city, you may also see a city wage tax that is withheld.
All of this money that is withheld is on your income tax return. Your tax refund is based on those figures. If you have paid too much according to IRS, then you get a refund. If you have not paid enough, you owe more money. If you paid the right amount, then you owe nothing but also do not get a tax refund.
What Are Income Brackets?
Your income tax bracket dictates the percentage that you pay in income taxes. There are marginal tax rates that are based upon your income level.
7 Ranges of Income
If you know which tax bracket you are in, you can better determine how much you will pay in income taxes. A tax bracket is an income range. There are seven ranges that cover every level of income. In addition to your actual income, your filing status also dictate the percentage of taxes that you pay.
Your tax bracket and how much you have paid in taxes are an indicator how your taxes refund. As you earn more, the amount of tax you owe also goes up. If you are single and you only make $8,000, you may owe 10 percent in taxes, but if your earnings go up to $600,000, then you owe 37 percent in taxes.
There have been some bills for Tax Reform which helps people by changing the amount of money you make before you go into a higher tax bracket. Also, it has corrected the tax increase that people have found happens when they get married. Prior to 2017, when two people got married, their incomes were combined which typically put them in a higher income bracket. With the changes in 2017, a married couple now doubles their amount, which allows them to pay the same amount as an individual.
What If I Am Self Employed
If you are self employed, I would recommend that you hire a professional to help you with your taxes.
Hire a Tax Professional
You should do this, at least the first year so you can maximize your deductions and tax refund. You should go to a tax store to find assistance. Once thing that you should keep in mind if you are self employed, or do any type of contract work is that you are not having taxes withheld from your income. You should either be prepared to pay your taxes when you file them, or pay quarterly taxes, or save a percentage of money every time you get paid.
Tax Reform
There have also been some tax changes for the self employed. The highest tax percent rate changed from 35 percent to 21 percent. The thought behind this decrease is to allow small business to hold on to their money and put it back into the economy. Another change is a deduction for depreciation of assets in one year, the year of purchase, as opposed to having to take the deduction over time. The amount of the deduction can be as much as $1,000,000.
Conclusion
I have given you a lot of information about income taxes and tax refunds. When it comes to paying taxes, it can be a stressful situation for many people. Even when you think you have paid enough taxes throughout the year, it is stressful to think you may owe money to the IRS. Few of us really want to be in the position of owing money to the IRS. Many of us question if it is better to get a refund, or owe money to the IRS.
When you look at it as the difference between you lending your money tax free to the government or you paying the government back money that they let you borrow tax free. It depends on your situation and if you can afford to have more money taken out of your paycheck. Some just cannot afford to have any more money taken out of our paychecks. So, we have to hope that we breakeven or get a refund when we file our tax return.
If you can afford to have a little more money taken out of each paycheck, you should do so in an effort to breakeven at tax time.