A Simple Explanation of Tax Withholding, Tax Returns and Tax Refunds

It’s tax time ladies and gentlemen. Recently, I did a simple explanation of how tax brackets work. Now, it’s time to talk about some other aspects of taxes. After all, it’s an apt time to discuss taxes in general as the tax return due date is 4/15. That’s just slightly more than a month away. It’s that exciting time of year again! Your chance to gather up all of your income statements and try to deal with the various IRS forms.

Taxes are a complicated thing. People still often confuse the various terms that come up when discussing them. As such, here’s a simple(ish) explanation of the three most common terms that are confusing. I use the term -ish because taxes are never that simple.

Tax Withholding

Everyone’s journey with taxes begins with tax withholding. You get your first job and your employer asks you to fill out a W-4 form.

This form allows you to guide your employer in best estimating the amount of taxes to remove from your gross pay based on your personal situation. After all, there’s this entity called the government, both state and federal. These guys want a piece of your income via the form of taxes for services they provide. Remember that gross salary? Well, now it’s a lot smaller!

When you’re employed, your employer acts as an intermediary for you in that regard. They use formulas given to them by the IRS to determine your tax liability. This is called tax withholding. It is the reason you see an automatic deduction from your paycheck each pay period. They take this estimated tax removed from your pay and send it directly to the government for you. How nice of them!

The formulas aren’t something I’ll dive into detail. However, they start with a certain amount taken account that can be adjusted by you!

The W-4 form allows you to adjust the amount they take out by claiming allowances which reduce your tax liability. Allowances are basically exemptions from paying tax on a part of your income. The reasons that allowances exist is because people do not owe taxes on the entirety of their income. For example, in 2019, single filers can claim a standard deduction of $12,200 reducing their taxable income by that amount. There are other deductions people can take that may decrease their tax liability. There are also factors that may increase your tax liability(usually other income outside of your job). That’s why the W-4 form exists to let your employer know about those details.

Allowances can get complicated. Once nice thing is that the IRS provides an excellent and simple calculator to figure out the proper amount of allowances to put for your situation right here.

One thing to remember is that the more allowances you claim, the less tax is withheld from your check. That means a bigger check but can also lead to an incorrect amount of taxes taken out. If you tell your employer to withhold too little, you may owe more money or have to pay fees.

The important thing to remember when talking about tax withholding is that it is an ESTIMATE of taxes owed. Your employer does the best job it can to estimate them accurately. They do that based on the IRS formulas and the information you provide them. However, they’re not always going to be exactly accurate for your specific situation.

Tax Return

That’s where the tax return comes into play. The tax return a fun annual exercise you might already be familiar with. Using standard, often complicated forms, you fill out a report of your income with the IRS or state government and determine your actual tax liability.

You can either do this yourself using tax software or hire an accountant to do it for you.

The tax return is what everybody thinks of when they think of taxes. It’s the filing aspect of taxes. Think 1040 forms and all that jazz. You input information from your W-2 and other income forms you receive and figure out how much taxes you actually owe for the year.

After all, when your employer withholds taxes, they are estimating the amount you’ll owe based on info you gave them. It is not going to be 100% accurate. It is based on the information provided to them by you and the IRS. That estimate can often be wrong. Formulas are never going to be accurate for every tax payer. In fact, they’re rarely 100% accurate.

That’s why we have to do the tax return. The tax return is designed to calculate the ACTUAL amount of taxes you owe and see if the amount your employer WITHHELD was correct.

Tax Refund

If the amount withheld was too high, you receive the vaunted tax refund. It’s the money many happily get back at the end of the year.

If you amount withheld was too low, you owe additional taxes and may have to pay a penalty.

A tax refund is often well received since it means an influx of cash right around tax season.

However, in reality, the receipt of a tax refund simply means one thing. It’s that your employer gave the government too much of your money based on the W-4 information. You allowed them to withhold TOO MUCH from your paycheck and now you get it back.

In essence, a refund of $2,000 at the end of the year means your paycheck was $77 too low each pay period assuming you get paid bi-weekly.

People have a tendency to focus on the tax refund too much. A big refund is seen as a good thing but it really isn’t if you think about it. It simply says that your let your employer withhold more money than they should have.

One key thing to remember is that the thing that really matters when it comes to taxes is tax liability; the actual tax amount owed based on your tax return.

Tax laws change and with it so do tax withholding tables. The withholding tables used in 2018 are different than those used in 2017. The recent changes in the tax law meant lower tax rates for most and smaller withholding from paychecks. They also meant changes to tax credits that may impact certain people negatively.

If the IRS formulas land you closer to the pin in one year versus the other, that may mean a bigger paycheck and a smaller refund.

After all, the tax return compares the actual amount withheld versus what you owe. If the numbers are closer together then your refund will be smaller. However, that does not mean you’re worse off if the actual taxes owed are lower than they were before.

If your question this year is why is my tax refund smaller this year than it was last year, the answer may be that you were more accurate in withholding it this year. It’s important to compare actual tax liability to see if the new tax laws benefited you.

A $2,000 refund due to $15,000 in taxes withheld versus $13,000 owed may make you smile.

However, a $100 refund due to $12,100 in taxes withheld versus $12,000 owed is actually better. It means more dollars in your pocket during the year due to a higher paycheck and less paid in taxes overall. The refund is smaller but your overall post-tax pay assuming the same gross salary is higher.

The tax refund simply tells you how accurate you were(via the W-4 form) in estimating your tax liability.

In fact, in a best case scenario, your tax refund should be $0.

That would mean your employer, using the information given to them via the W-4 by you, was able to perfectly estimate your tax liability as determined in your tax return. That means a higher paycheck throughout the year but no refund at the end of the year.

The end result is still the same. Instead of a $2,000 refund, you still get $2,000 but you get it in $77 chunks every two weeks due to lower withholding.

In essence, a refund at the end of the year means you are giving the government a $77 interest free loan each pay period. You’ll get it back at the end of the year after filing your tax return. However, wouldn’t it make more sense to get it every 2 weeks?

Sometimes, the $2,000 surprise at the end of the year is nice but it’s not always the best financial decision.

That’s why it’s important to look at your tax return and adjust your allowances using the W-4 form to get that withholding closer to the pin.

Taxes are never simple. There are some credits and outside income that is hard to estimate via allowances. At the end of the day, you might still end up missing the target. One thing to remember is that the government can charge you fees if you underpay so claiming too many allowances is a bad idea. Also note that there are some refundable tax credits that can provide you with a refund even if you don’t owe any taxes. These tax credits can lead to a refund even if you withholding was accurate.

However, in most situations, there are some basic guidelines for allowances you can follow. On top of that, this calculator should give you a good idea of what will work for you. You can also see a tax professional for advice.

And that’s the basics of the tax world. Easy right? Not! I hope I explained it in an understandable way. However, let me know if anything is confusing.

Again, in simple terms. Your employer estimates and withholds taxes from your gross pay to give to the government(using info you give them via the W-4 form). You file a tax return to calculate the actual amount owed. A tax refund means the amount owed is smaller than what was withheld and given to the government and you get the difference back. Remember, you will owe the difference if you withheld too little and may owe penalties.

That’s it and hopefully now you know the difference between tax withholding, tax returns and tax refunds if you didn’t before!