I usually try to write about frugal things on Fridays, but today I realized how many people don't understand how taxes work, or why or how they are getting a tax refund of whatever size. I've written about this before, but it's one of those things that some people need to hear explained one way and other people need to hear explained a different way, so I'm going to explain it again. Maybe one way or the other will work better for you. It's important to understand because if your taxes are out of whack, so is your monthly spending plan.
Every year at tax time, I hear a lot of confusion and speculation and complaints about how random our tax system seems. There's nothing random about it. It's really straightforward, and there shouldn't be a lot of surprises unless you have a particular complex situation. If you're not sure how taxes work, first read Rethink Your Big Tax Return.
There is one main thing that impact whether a taxpayer, or taxpayer family, receives a big or a small refund, or has to pay taxes at the end of the year: withholding. Whether you receive a refund has nothing to do with how much you pay in taxes. It's all about how much you owe as calculated on your income tax return at the end of the year vs. how much you've had taken out (withheld) over the year. Take out too much, you'll get a refund. Take out too little, you'll need to make a payment at the end of the year.
Understanding your taxes is key to having an accurate spending plan, or budget. If you're getting a big refund or paying a big bill, you're not attributing the right amount to taxes each month. Depending on how much money is involved, this can represent a significant portion of your monthly income and expenses.
For a completely hypothetical scenario, let's take an uncomplicated taxpayer who is making $4,000 per month and, after all the adding and subtracting, owes a total tax bill of $3,000 for the year.
If he is having $100 per month withheld for income taxes, and $500 deducted for other things, he's bringing home $3,400 per month. It would seem logical to build a spending plan around that amount. However, at the end of the year, he owe an additional $1,800 in income taxes. In reality, his monthly spending plan should be built around $3.250. He's been off by $150 per month all year.
If, instead, he's having $500 withheld for income taxes each month, and $500 deducted for other things, his take home pay is now $3,000 per month. At the end of the year, this taxpayer is gong to receive a refund of overpayment in the amount of $3,000.
With these two scenarios, the taxpayer is making the same amount of money, and paying the same amount of total income tax, but with one set-up he's paying a big tax bill and with the other set-up he's getting a huge refund.
Ideally, you want to have taxes withheld at a rate that your total tax bill is coming near to the amount you've had withheld, so that you either get a small refund or have a small additional tax bill. Doing this makes tax time easier and it gives you a more accurate monthly figure for your spending plans.
You control how much you have withheld when you fill out your W-4 Employee’s Withholding Allowance Certificate. Everyone fills out this form when they start a new job, and you should fill out a new form whenever you have a change in situation that will impact your taxes. Times you want to check your withholding include:
- getting married
- having a baby
- starting a new job (check all withholding, not just the new job.)
- buying or selling a house, or turning a house into a rental
- getting a raise
- starting a business