Taxes in and of themselves are not a bad thing. On some level, your taxes are going to pay for things that benefit the public as a whole, which no one entity would otherwise pay for. Paying too much, however, amounts to an interest free loan over and above your fair share. In this article, we’ll look at some things that often lead to overpaying taxes and how to avoid them.
A Clear Sign You’re Overpaying
The most obvious sign that you are paying too much tax is the size of your refund. The average refunds early in the filing season tend to be well over $2,000 as the people who know they are getting money back hurry to file. These refunds are understandable as life can happen late in a tax season. A child may be born, a job lost, a dependent may move in and the filer hasn’t had the time to adjust withholding. If you’re getting several thousand back year-after-year, however, then you are definitely paying too much in taxes. (For more, see: Understanding the U.S. Tax Withholding System.)
The most common life events that can cause the amounts you should be withholding off your checks include: (For more, see: When You Should Change Your Withholding Tax.)
- Marriage: If your spouse receives an income, this can impact your tax bill as a household. If your spouse is a dependent, then your withholding amounts should be adjusted down. Divorce obviously has an effect as well and requires an update, particularly when dependent children are involved.
- Addition to the family: The birth or adoption of a child reduces the amount you should be withholding because you are adding a dependent to your household.
- Changes in income: If you aren’t accounting for non-wage or second job income, you usually end up owning the government more. If you adjusted your withholding up to reflect other income and these sources dry up - a bad year in a side business for example - then those extra withholding amounts need to be removed.
Some company payroll departments will prompt you to update the W-4 if they are aware of these life changes. For most people, however, it falls on you to get the updated paperwork to them. (For more, see: Filling Out Your W-4 Form.)
Any time you can expect a large tax credit or deduction, it makes sense to adjust your withholding down sooner rather than waiting for the return. There is a growing opportunity cost the longer you wait for the money. In addition to the three examples above, there are education credits, dependent care credits, charitable giving deductions and other things that can be converted to withholding reductions using worksheets from the Internal Revenue Service (IRS). (For more, see: How to Owe Nothing on Your Federal Tax Return.)
In fact, instead of waiting for the return and adjusting your W-4 for the year ahead, you can work through the IRS’s own withholding calculator and even run some scenarios.
The Bottom Line
Of course we probably all feel like we are paying too much tax. If you are getting a big check back from the IRS on a regular basis, then you really are paying more than your fair share. It does feel good to get that lump sum payment, but from an economic perspective it is better to keep that money from coming out of your check in the first place. Even the IRS encourages people to be more accurate with their withholding by providing guides and calculators. So, if you find yourself getting those big checks on an annual basis, it is time to update your W-4. Although it will feel a bit anticlimactic at tax time, the ideal tax refund is zero. (For more, see: Tax Withholding: Good for Government, Bad for Taxpayers.)