When the tedium of filing your tax return is finally over, usually you receive a refund with all the excess money the government collected beyond your actual tax liability. Many taxpayers look for opportunities to reduce their overall tax bill to get a larger refund check, and while there is some logic to this, there’s also a big drawback.
There are several ways to reduce your overall tax liability, and understanding these mechanics will show you why a large tax refund may not be the treat you think it is.
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1. Choose the right tax filing status
There are five tax filing statuses for you to choose from: single, head of household, married filing jointly, married filing separately, and qualified widow(er). Using the right one is important because it affects your standard deduction and your income tax bracket.
Here’s an illustration to stress the importance of filing status: If you’re unmarried but supporting a child or elderly parent and you pay more than half of the bills, you’re better off filing as a head of household than single. You’ll get an $18,000 standard deduction, versus the $12,000 standard deduction that single adults get in 2018. This means that your taxable income is automatically reduced by $18,000. If you earned $50,000 in 2018 and you have an $18,000 standard deduction, you’ll only pay taxes on the remaining $32,000. The income tax brackets are also different for single adults and heads of households, enabling heads of households to earn more money, while paying a lower percentage of their income in taxes than their single-filing counterparts.
Most married couples should file jointly because they get double the standard deduction of married couples filing separately and single filers. They can also earn double what married couples filing separately and single filers can earn before moving up to the next income tax bracket. Couples filing separately usually pay more, but you may want to consider it if you and your spouse are separating. Married couples filing separately are subject to the same standard deductions and income tax brackets as single filers.
Qualifying widow(er) status is available to adults who recently lost a spouse and are raising their child. It essentially enables widows and widowers to receive all the benefits of a married couple filing jointly, even though their spouse is deceased. For the tax year during which your spouse died, you can still file a joint tax return. After that, you can use qualified widow(er) status for the following two years, unless you remarry.
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2. Take advantage of deductions
You may qualify for tax deductions for things like contributions to tax-deferred retirement accounts or a health savings account (HSA), charitable contributions, or student loan interest and self-employment expenses if you own your own business. In some cases, like 401(k) contributions, you can write off the full amount from your taxable income; in others, like a home office deduction, you may only be able to deduct a portion of your expenses.
Tax deductions reduce your taxable income for the year. If you earned $50,000 and you qualified for $15,000 in deductions, you would only pay taxes on the remaining $35,000. This reduction might move you to a lower tax bracket, meaning you lose a smaller percentage of your income to the government. But even if it doesn’t change your tax bracket, it will still reduce the total amount you owe in taxes.
You have a choice between the standard deduction for your filing status or itemizing your deductions. This is where you enter all your tax-deductible expenses manually and total them. If you’re using tax filing software, it automatically files your taxes with the greater of the standard deduction or your itemized deductions. Tax software will help you determine which tax deductions you qualify for as well. You can also ask an accountant or tax professional.
Here are the standard deductions for each tax filing status:
3. Don’t forget about credits
Tax credits reduce your tax liability dollar-for-dollar, rather than just reducing your taxable income, which means tax credits are a more powerful tool than deductions, but they are also more rare to qualify for.
If you qualify for a $1,000 tax credit, your tax bill is automatically reduced by $1,000. Tax credits may either be nonrefundable — in which case they can lower your tax bill to $0, but no further — or refundable. If your refundable tax credits exceed your tax liability, the government will actually pay you the difference.
Common tax credits include the Earned Income Tax Credit (also called the EITC or child tax credit) for low-income earners. This is a refundable tax credit that could be worth anywhere from $519 to $6,431 in 2018, depending on your tax filing status and number of dependent children. There’s also the Savers Credit that rewards low-income households for contributing to a retirement account. It’s worth up to $1,000 in 2018 for single adults or $2,000 for married couples filing jointly.
There are other tax credits for things like higher education costs and caring for dependents, but most have strict eligibility requirements that may change from year to year. Your tax software or accountant will help you determine which credits you qualify for.
Why a large tax refund isn’t always good
Your tax refund is your money that the government withheld from you unnecessarily all year. You don’t receive any interest on top of the amount you’re owed, so it’s essentially like you gave the government an interest-free loan. If the money wasn’t taken out of your paychecks, you would have had it sooner, for spending, saving, paying down debt or investing.
If you receive large refund checks, it could be a sign you’re not claiming enough allowances on your taxes. The number of allowances you claim tells your employer how much money to withhold from each of your paychecks. Check with your employer if you’re not sure how many allowances you’re claiming now. Then, use the IRS withholding calculator to figure out how many you should be claiming.
When you claim more allowances, the government will take less money out of each paycheck. This may result in a smaller refund check, but that’s not a bad thing. It means the government isn’t taking much more of your money than it should and you can use it as you earn it.
A big tax refund means that you’ll wait longer to access all of your hard-earned cash. Take advantage of all the deductions and credits you qualify for in order to reduce your taxes. But make sure you’re claiming the right amount of exemptions, too, so you don’t have to wait until you file your taxes to get the money you deserve.
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