Getting a Big Tax Refund

We all like it. A nice big check from Uncle Sam on that wonderfully colorful Treasury check paper, just sitting in our mailbox in May or June. Oh what will we do with this 'found money'. Perhaps take that nice vacation. A swimming pool for the kids? A down payment on that sporty car you have been looking at? You know, they are making 60" plasma TVs now that are under $3000!

Wow. Hold on there. This really isn't a gift from Uncle Sam. Actually, he is returning the loan you gave him last year. That 0% loan you kindly gave him, a little bit every pay day. I'll bet you didn't realize you were floating the federal government some of your hard earned money, and feeling pretty happy about it when you got it back a year later with no interest added!

One of the problems is that even when we go through all the instructions on the W-4 form to properly calculate the number of exemptions we should claim, the formula still over estimates the amount of Federal tax withheld from our paychecks. Few people feel good about getting no money back from their Federal Tax return and even fewer want to come up with money to pay any extra tax owed at tax time.

The tax refund has become part of our seasonal holidays and a gift receiving holiday it is! Our tax refunds come about half way between Valentine's Day and Christmas and is often received just when the weather is turning warmer. Summer is coming, we have new money, life is good!

Uncle Sam has been pretty happy as well. How nice that we can do something that makes everyone happy!

Most accountants will suggest that we make our Uncle a little less happy by calculating our tax withholding so we wind up getting a $0 return. Some accountants may even suggest intentionally under-estimating, so you are effectively getting an interest free loan, although I do not suggest this approach for most people.

What I suggest you do:

Work with your accountant or do the math yourself to figure out the following:

1) What is your estimated tax responsibility for the current year?

2) How much was your tax responsibility for the previous year?

This is not how much you paid at tax time or even the amount you see on your W-2 form. It is the amount of Federal Tax you owe for the year as it shows on your 1040 Tax return. On the 2008 form it was Line 61 (TOTAL TAX).

You want to pay enough tax during the year that you are not going to be penalized. You also don't want to pay so much that you wind up giving the Federal Government this generous interest free loan for 1 year.

Accountants will have different suggestions of exactly what you should do, but here is a very basic strategy:

1) Unless you are making a lot less money than last year, make sure your payroll Federal tax withholding adds up to AT LEAST the amount of your TOTAL TAX for the previous year. Generally, (everything dealing with the IRS has some amount of variation), you will not be penalized if you pay AT LEAST the tax you owed the previous year OR at least 90% of the tax you do owe for the current year. (Disclaimer - If your income for this year is substantially more than last year and you were aware of it early enough in the year, you could wind up having some trouble if you are audited, so get some good advice).

2) Estimate your Total Tax for the current year. Do you best, but don't sweat it, you'll be wrong, but you just need to get close.

3) Decide how close you want to make your tax deductions to the total tax you wind up owing. a $5,000 margin is being to generous to Uncle Sam. 5-10% is probably a good guideline. (If 5-10% of your total tax is $5,000, congratulations on your income level and thank-you for helping to reduce the national debt.)

4) Add your margin to your estimated Total Tax for the current year.

5) Go with the higher of your total from 4) and your total tax from last year.

In addition to using the exemptions on your W-4 form instruct your Payroll Department how much federal tax to withhold for you, you can actually give them the exact amount you want taken out. So, if you know what total withholding you want for the year and how much has been withheld to date, subtract one from the other and divide that by the number of remaining payrolls for the year.

If you are uncomfortable with the possibility that you may have estimated low and don't want to have to figure out how to pay the government the extra you owe them next April 15th, here is a nice solution:

Every month, instead of paying an extra $100-200 in Federal Tax Withholding, have that auto-deducted from your payroll and invested in a money market account. Instead of giving the 0% loan to Uncle Sam, you are keeping the money yourself and earning some interest (although not much as of this writing). If at tax time next year you need this extra money, you will have it.

If you wind up having done some pretty good tax estimations and you don't need this money, then maybe that Cruise to Bermuda is a possibility after all. But perhaps it shouldn't be. In an upcoming article, we will write about how we think and spend differently depending upon whether we receive money in a lump sum or over a period of time.