Focusing on a Tax Refund? Do Some Tax Planning Instead
Dear Carrie: When I did my taxes this year, I wound up owing a lot to the IRS. A friend at work mentioned they got a huge tax refund. How can I get a refund next year? -- A Reader
Dear Reader: The end of tax season always brings a host of questions from readers. Mostly they boil down to "How can I pay less in taxes?" or "How can I get a bigger refund?" Many readers don't realize that these are two very different questions. Let's explain the difference and then talk about a few steps you can take to minimize your overall tax bill, keeping more money in your pocket.
Tax Refunds and Tax Rates
I've discussed before why getting a big tax refund isn't the best thing, but I want to remind readers that a refund doesn't mean you're paying less in taxes. A tax refund simply means that you gave the government a zero-interest loan the prior year. The bigger your refund, the more money you lent.
In the same way, having to pay taxes when filing doesn't mean you're paying more in taxes. It just means you had less withheld than you owed during the prior year.
What's more important is your effective tax rate, or the total amount of tax you pay divided by your taxable income. This percentage should be your main focus, not whether you got a refund or owed additional taxes.
Check Your Withholding
To make sure you're not overpaying or underpaying, check to see if you have the right amount of taxes being withheld from your income via the IRS Tax Withholding Estimator. You can also make quarterly estimated tax payments to the IRS if you don't have taxes withheld from your income.
It's important not to under-withhold by too big of a margin, as that can trigger a penalty. Be sure to account for bonuses, investment income and other income sources like rental income to ensure that you are withholding the right amount.