Avoiding a Tax Refund

April 5, 2016

Author: Dave Gardner

Your tax refund may be the biggest check you receive all year.  It’s like Christmas in April with many taxpayers as the happiness a tax refund check brings to the household exceeds its monetary value.  It’s almost like a 2X giddiness factor: $1,000 back from the IRS feels like $2,000 from anyone else.  And it’s a classic win-win for you and the federal government.  They get free access to your money and you feel wonderful about it.

I’ve never been a big advocate of deliberately manufacturing a big tax refund.  For many years, my biggest issue was that when you receive a refund it’s the result of withholding too much in taxes.  A $1,000 tax refund is the result of tax that you have overpaid throughout the entire last year.  The IRS levies interest if they determine through convoluted rules that you have underpaid taxes.    However, if you overpay your taxes through the year, you receive absolutely nothing in interest.  You have charitably given the IRS free use of your funds over the last year for free.

Of course there are many smart taxpayers that still love the big refund.  Withholding too much is a method of forced savings.  If they have less withheld from each paycheck, it may just disappear as part of daily spending.  But if come tax time they get a big check, it can be used for something purposeful whether it’s college savings or an important purchase.

I’ll concede that “tax savers” have a reasonable point.   But with recent developments there are 21 billion reasons to avoid this.  That is the dollar amount the IRS estimates it will pay out this year for fraudulent tax returns.  Fraudsters steal your identity, file a tax return in your name, and receive the refund that was intended for you.  When you file your legitimate tax return expecting prompt payment of a refund, you instead get a fraud notification that could result in wasting countless hours of your time and a delay in receiving your refund of up to 18 months.

While the IRS has dramatically increased its efforts to reduce tax return fraud, you don’t have to wait for the government to help you.  By taking steps to reduce or eliminate your refund, the fraudster filing a return in your name will have nothing to steal.  Not only does this help your personal finances, but your fellow taxpayers thank you because the IRS will not be cutting checks to criminals for your tax refund.

You can take this fear of refunds too far.  You must meet at least one of the three major IRS “safe harbor” rules to avoid paying interest to the IRS.  First, withhold (and/or or pay in equal estimated tax payments) at least 90 percent of what you owe.  Second, withhold at least 100 percent (110 percent for higher income earners) of what you paid in tax the previous tax year.  Third owe no more than $1,000 when you file your taxes.  As long as you stick to at least one of these rules, then most likely you will not pay an IRS penalty.

Say you file your 2015 taxes and find that you owe $2,000 in taxes with a total tax of $23,000.  You are higher income with a married filing jointly AGI of $160,000 and paid $22,000 in taxes for 2014.  You owe more than $1,000 and you have not withheld 110 percent of your 2014 taxes, so you miss two of the safe harbor rules.  But you have withheld at least 90 percent of your 2015 taxes ($21,000 withheld divided by $23,000 of total tax is 91 percent), so you won’t pay a penalty under most circumstances.

Reducing your tax withholding can be daunting if you’re unfamiliar with the obscure Form W-4 you turned into your employer when you first started.  To reduce tax withholding, submit a revised W-4 to your employer with an increased number of exemptions.  Each additional exemption you claim means that your employer will withhold tax on roughly $4,000 less in income.

So if you’re in the 25 percent federal tax bracket, this would mean $1,000 less per year would be withheld with each additional exemption.  The IRS has a withholding calculator on its website (https://www.irs.gov/Individuals/IRS-Withholding-Calculator) that can help.  Consulting a tax pro on this can help make this simple.   Just remember if you can get your refund down to zero, the fraudsters will move on when it comes time to steal your identity.

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About Dave Gardner

David Gardner is a certified financial planner with a practice in Boulder County and can be reached at dave@confluencefa.com and at twitter.com/Dave_CFP.