Woman Doing Taxes
Filing your taxes can feel less daunting when you anticipate a substantial refund; however, a large tax return may not be as favorable as it seems. According to Ashley Weeks, a wealth advisor at TD Wealth, it’s wise to consider minimizing your tax return for future years.
A tax refund is essentially a reimbursement for the excess state and federal taxes you’ve paid throughout the year. When the IRS sends you money after you file your taxes, it indicates you’ve overpaid. Weeks explains, “It’s essentially an interest-free loan made to the government that you only get back in April of the year after you issued the loan.”
“The first thing I tell clients when they receive a larger-than-expected refund is to take a breath, assess why the refund was so significant, and make some adjustments for the next year,” Weeks advises. “If you’re getting more than $1,000 back, there’s likely room for optimizing your withholding strategy.”
Most often, clients end up with a sizable refund because they overpay taxes through their W-2 job during the year. In such cases, Weeks recommends consulting with the HR department to adjust your Form W-4, which dictates how much tax your employer withholds. The IRS advises filling out a new Form W-4 every year or whenever there’s a change in your financial situation.
Regularly reviewing your W-4 is essential to ensure that your information remains current. Weeks notes, “It’s a form that many people only complete when starting with an employer and rarely revisit. Obviously, life changes—income can increase, there may be additional sources of income from side jobs, and personal circumstances such as having children or acquiring more deductions can occur.”
Real estate investors and self-employed individuals often face similar over-withholding challenges, Weeks points out. Income taxes are continuously collected, which is why employers deduct taxes from each paycheck. For those earning income independently, the IRS mandates quarterly estimated tax payments. You can estimate these payments based on the previous year or annualize them based on your income earned thus far this year.
Overestimating your quarterly taxes could lead to a more significant tax return. If you believe you’re overpaying, you can adjust the numbers on Form 1040-ES.
Many taxpayers enjoy the boost of a lump sum payment in April. Some of Weeks’ clients view their tax return as a “forced savings mechanism.” For those receiving one, she recommends using the refund to pay off high-interest debt and establish an emergency fund.
However, this tax return comes at a price. If you hadn’t overpaid during the year, you could have used that extra money to pay off debt, save for a significant purchase, or invest. The goal should be to keep more of your funds easily accessible throughout the year. “It’s just probably not the optimal strategy because the government holds that money and doesn’t pay any interest,” Weeks cautions. “This can be detrimental if someone has to resort to additional credit card debt to manage expenses or if they decrease their retirement savings because they lack liquidity due to that money being held by the government.”
