When you earn an income during the year, you’re required to pay taxes on it that year. You authorize your employer to withhold a certain amount of taxes from your paycheck, or, if you’re an independent contractor, you pay estimated taxes on your own.
If you did the complex and mystifying math correctly, then on Tax Day you should neither receive a refund nor owe additional taxes. That means you were fortunate enough to know every tax deduction and credit you could claim, even though many people may be unaware.
But if, on Tax Day, you fill out your tax return and discover that your employer withheld too little, or if you claimed deductions, credits, or exemptions that you weren’t supposed to claim, then you’ll owe taxes on top of what you paid throughout the previous year. (Read more about filing your taxes.)
On the other hand, if you fill out your tax return and discover that your employer withheld too much, or if you didn’t claim deductions, credits, or exemptions that you were eligible for, then you’ll receive a refund. While a refund is nice to have, it also means that throughout the year your paychecks were lower than they should’ve been had you known you were overpaying.
How tax refunds work
There are two types of income you need to think about when figuring out your taxes:
Your gross income, which is the amount you earn before subtracting taxes and adding personal allowances – your deductions, credits, and exemptions.
Your taxable income, which is the amount of income that you actually have to pay taxes on after accounting for your personal allowances.
You should also know how personal allowances work:
Deductions reduce your taxable income. If you earn $50,000, but had $15,000 in deductions, then you can only be taxed on $35,000.
Exemptions are an additional type of deduction. The most commonly claimed federal exemptions were removed by the Tax Cuts and Jobs Act of 2017; most people cannot claim any, although some people may be able to claim them for their state and local taxes.
Credits are a reimbursement for taxes you paid during the year. If you owe $4,000 in taxes but receive a credit for $1,000, then you only need to pay $3,000.
Read more about the difference between credits and deductions.
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Most individuals claim the standard deduction, which, as of 2021, reduces their taxable income by $12,550. (The standard deduction will increase to $12,950 in 2022.) Other people itemize their deductions if their total amount of deductions for the year exceeded the standard deduction.
Say you earn $52,000 in 2021. Your taxable income is $39,450 after applying the standard deduction. In this example, you should owe about $4,535 in taxes that year before applying any credits.
How do we know? Because the U.S. uses a set of tax brackets that get progressively higher the more income you earn. For tax year 2021, the U.S. federal income tax brackets for people filing taxes as an individual are as follows:
|TAX RATE||INCOME RANGE|
|10% on every dollar earned between||$0 and $9,950|
|12% on every dollar earned between||$9,950 and $40,525|
|22% on every dollar earned between||$40,525 and $86,375|
|24% on every dollar earned between||$86,375 and $164,925|
|32% on every dollar earned between||$164,925 and $209,425|
|35% on every dollar earned between||$209,425 and $523,600|
|37% on every dollar earned above||$523,600|
Someone whose taxable income is $100,000 pays $995 for the first bracket, $3,669 for the second bracket, $10,087 in the third bracket, and $3,270 in the fourth bracket (24% of the difference between $100,000 and $85,525). Their total federal tax bill should be over $18,000 before any other applicable credits or deductions.
Per our example, the $4,535 you owe in taxes should come out of your wages that year. But say your employer only withheld $4,000. You would’ve enjoyed a higher paycheck throughout the year, but when you file your tax return, you’ll receive a tax bill for the remaining $535.
However, if you owed $4,535 and your employer withheld $5,535 during the year, then you’re due for a refund of $1,000.
If you’re an independent contractor, paying taxes works a little differently. In this case, nobody is automatically withholding taxes from your paychecks. You need to pay this tax on your own by making estimated payments during the year. But, on Tax Day, you’re still eligible for a refund if you overpaid your estimated tax and vice versa.
Updating your withholding
If you owe taxes on Tax Day or receive a tax refund, that means your withholding wasn’t calculated correctly during the year.
When you first started working for your employer, you filled out a Form W-4, which authorizes your employer to automatically withhold taxes from your paychecks. On Form W-4, you indicate a series of “personal allowances” that you’re claiming, which include deductions and credits you may be eligible for.
In the rush to start a new job, not everyone fills out their W-4 correctly. Some people may underestimate which credits or deductions they’re eligible for; other people may overestimate. When your employer starts withholding taxes from your paychecks, they may be unknowingly withholding too much or too little.
But you can update your withholding at any time by filing a new W-4. Ask your employer for a new copy of the form and be sure to fill it out accurately. Your employer will submit the form to the Internal Revenue Service (IRS), but it could take at least one pay cycle for the changes to take effect.
If you’re an independent contractor, you don’t fill out a W-4, since it’s not your clients’ responsibility to withhold taxes from your paycheck. Independent contractors do file Form W-9, but that document only provides information about you and the type of business you run.
The IRS offers numerous credits for taxpayers. You can claim these credits on your W-4 to reduce the amount of tax withheld from each paycheck. If you don’t claim these credits during the year, you can still claim them on Tax Day when you file your return.
Some tax credits are refundable. That means you can claim the tax credit even if you don’t owe any taxes that year and still receive most of the base amount.
For example, the child tax credit can reduce your tax liability by up to $2,000 per child. If you would otherwise owe $5,000 in taxes and claim the child tax credit for one child, then you owe only $3,000 instead. But if you didn’t owe anything that year, perhaps because you claimed other credits and deductions, then you can still redeem the child tax credit as a refund for up to $1,400. The child tax credit was also temporarily increased to $3,600 in 2021, thanks to COVID-19 relief measures passed by the Biden Administration.
The “interest-free loan” to the IRS
We caution against aiming for a large tax refund because that means you’re overpaying taxes throughout the year and in return receiving a smaller paycheck. Some people describe this as giving the IRS an “interest-free loan.”
For example, if you overpaid your taxes by $1,000, then you’re eligible for a refund of $1,000 when you file your tax return. But if you were a bank and the IRS were a customer, you’d get to charge interest on that $1,000. Say the interest rate is 5%; when the “IRS” pays you back, you’d be due $1,050.
But that’s not how it works. Instead, you gave the IRS extra cash and let them hold onto it for a year or more.
A better way would be to set your withholding so you’re not paying too much during the year. The IRS offers a withholding calculator that can help do just that.
If you use the correct withholding, you’ll get a $0 refund, but you’ll also receive a slightly larger paycheck throughout the tax year. The best part is you can invest the difference and earn interest on that amount. We recommend a high-yield savings account.
Some people enjoy receiving a lump-sum refund payment. But it actually has two serious disadvantages compared to updating your withholding:
Because of inflation, the money you overpay throughout the year will be worth slightly less when you receive it back as a refund the following year.
If you lose your job or need money in an emergency, having more cash on hand (because you weren’t overpaying your taxes in expectation of a refund) could be a huge help if you can’t survive until Tax Day.
Where’s my refund?
Claiming some tax credits could increase the processing time for your refund. Any errors on your tax return could also cause an additional wait.
The IRS’s “Where’s My Refund?” service will tell you the status of your refund. If you mailed your tax return, information about your refund should be available within four weeks. If you filed electronically, that information should be available within 24 hours.
You may also be owed a refund for prior years, especially if you didn’t file a return those years. After filing a return for prior-year taxes, if you’re eligible for a refund then it will show up on the “Where’s My Refund?” service. However, only the most recent year’s tax return will be displayed, even if you filed prior-year tax returns after filing your current year’s.
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