As I stumble around the internet, I hear a lot of interesting discussion regarding income taxes, tax returns, refunds, and payments. I’ve heard of people owing lots, and people who get huge refunds. What I find most interesting is that many people seem to think that it is this random, mysterious situation, almost as if they have no control over whether they owe or receive a refund. If you are one of those people, I’ll let you in on a little secret: you have total control over the size of your refund (or how much you still owe.)
A more accurate term to describe a tax refund is a tax overpayment, and a more accurate way to describe a payment made with your taxes is that those are additional taxes due. Income taxes are basically a yearly bill. The amount of the bill is calculated on a variety of factors and is calculated on the whole year. During the year, you make payments towards this yearly bill in the form of withholding (these are the taxes that are taken out of each paycheck.) At the end of the year, you tally up the bill (your income tax return) and figure out how much of the bill is still yet to be paid, or if you have overpaid and are due a refund. The total amount of taxes due for the year does not change as a result of the amount you have withheld from each pay.
The size of an income tax refund is directly tied to how much taxes you pay-as-you-go (through withholding) throughout the year. If you pay too much, or you have a significant number of credits, you will get a large refund. If you pay just the right amount, you will get a small refund, or perhaps owe a little. If you don’t have enough withheld during the year, you will owe a lot when you file your income tax return.
This concept is remarkably difficult for many people, so I’ll give you a very simple example. Let’s say that for your taxable income, you owe taxes in the amount of $2000 for the entire year. If you had $3000 in taxes withheld through the year, you would get a $1000 refund. If you had $2000 in taxes withheld through the year, you would get no refund. If you only had $1000 withheld through the year, you would owe $1000.
Now, let’s make that example a little more complicated. Let’s say you still owed $2000 in taxes, but you have a child and are able to claim the $1000 child tax credit. This would bring your tax liability down to $1000. Using the same three withholding amounts above, you would have different results. If you had $3000 in taxes withheld through the year, you would get a $2000 tax refund. If you had $2000 in taxes withheld through the year, you would get a $1000 tax refund. If you had $1000 in taxes withheld through the year, you would neither receive a refund nor owe additional taxes.
For those of you who completely understand this process, I apologize. Many folks have incredible trouble with the concept, and they can’t understand how their neighbor got $7000 back and they owed $2000. I will continue to explain it a variety of different ways to help people learn.
Want to learn more? See What Is Income Tax Withholding and Why You Want to Get It Right for a more in-depth explanation of the withholding and taxation process.