Tax season 2020: Do you really understand how tax refunds work?

You just might be one of the 96 million Americans awaiting a tax refund in early 2020, but do you fully grasp what a tax refund is…and how it works?

5 questions your accountant should know

Most Americans don’t understand how tax refunds work.

According to a Credit Karma survey of more than 1,000 taxpayers, only 46% understood the reason that they get a tax refund from Uncle Sam. About half of Americans mistakenly view their tax refunds as “payments” from the government.

What is a Tax Refund?

A tax refund is:

the return of an excess amount of income tax that a taxpayer has paid to the state or federal government within the past year, usually in the form of withholding from a paycheck or payments of quarterly estimated taxes. – Investopedia

In other words, your refund money technically comes from your own paycheck.

And if you don’t understand that refunds stem from tax overpayment, you’re going to miss opportunities to shape your yearly finances for the better.

What’s the harm in overpaying the IRS if the money get’s returned to you?

More than half of taxpayers surveyed by Credit Karma said they’d rather get a tax refund than receive more money in each paycheck throughout the year. It’s easy to see why: The average refund last year was $2,725. For 44% of Americans, their tax refunds were their biggest “paychecks” of the year.

For many of us, tax refunds represent an opportunity to catch up on bills, take a vacation or pay off debt. Whereas that $2,725 divided into 24 bimonthly installments is only an additional $113 per paycheck.

by overpaying the irs, you’re giving the government an interest-free loan

It’s logical to equate a tax refund to an enforced savings account. By overpaying the IRS, you’re effectively locking up money that can be used later when you get your refund.

However, relying on the IRS to hold your money may not be the smartest tactic.

  • For one, the IRS doesn’t pay interest when they return your money. Contrarily, if you had placed those funds into a high-interest savings account – paying rates of about 2% – you’d be able to grow your savings throughout the year.
  • And unlike a bank account, you can’t withdraw your money in an emergency situation once the government has it.

The bottom line is— if you’re relying on your tax refund for financial stability, you may want to rethink your strategy. Keeping more money in your paychecks is likely the wiser option, especially for those with little or no savings.

If you’re like most people and your taxes are automatically withheld from your paycheck, you can tweak your expected IRS refunds by revising your W-4 form with your employer.

Early 2020 could be an opportunity to reexamine your tax strategies. Contact our office below for an easy, no-hassle quote on individual or business tax services
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