Getting a tax refund can seem like a financial windfall, but it means you’ve overpaid your taxes and given the government an interest-free loan. While some taxpayers prefer to receive a lump sum refund, others view tax overpayments as a missed opportunity to have their money work for them. That’s because the extra money paid to the IRS could be invested or saved throughout the year, generating interest instead of sitting idly in government coffers. Avoiding a tax overpayment often comes down to figuring out the correct amount that should be withheld from your paycheck.
How Do You End Up Overpaying Your Taxes?
Taxes are a complex and often daunting aspect of financial management. Many individuals find themselves inadvertently overpaying on their taxes due to a lack of understanding or attention to detail regarding their tax obligations. The common causes of overpayment can range from failing to adjust withholdings after significant life events to misunderstanding the tax code.
For instance, getting married can impact your federal tax bracket and available deductions, while the arrival of a new child might qualify you for additional credits, such as the Child Tax Credit. If these life events are not accounted for by adjusting tax withholdings, one could end up paying more taxes than necessary.
Furthermore, income changes from job loss, retirement or a transition to part-time work could also send you into a lower tax bracket and result in a tax overpayment. Staying informed and managing withholdings are both paramount in avoiding overpayment of taxes.
Strategies to Avoid Tax Overpayment
Considering the time value of money, money at your disposal now is inherently more valuable than the same amount in the future due to its potential earning capacity. Consequently, overpaying taxes is akin to lending the government money but receiving no interest for the loan. Doing so deprives yourself of the earnings that could have been accumulated had you saved or invested the extra money you paid the IRS.
To prevent overpayment of taxes, adjusting your tax withholdings is a wise decision. Tax withholdings refer to the portion of your income that your employer deducts from your paycheck to cover your federal and state income taxes, as well as other applicable taxes like Social Security and Medicare. These income tax withholdings are based on information provided on your W-4 form, which you complete when starting a new job or whenever your personal or financial circumstances change.
Tools like the IRS tax withholding estimator are invaluable in helping estimate the correct amount to withhold from your paycheck. This tool considers factors such as income, deductions and tax credits to help you make an informed decision. By accurately adjusting your withholdings, you can avoid overpaying taxes and giving the government an interest-free loan.
Life events such as marriage, divorce or receiving an inheritance can significantly alter your tax situation. It’s important to reassess your withholdings periodically – not just during these events – to ensure they reflect your current financial circumstances.
Meanwhile, itemized deductions, such as mortgage interest, property taxes and charitable contributions, as well as tax credits like the earned income tax credit (EITC) and child tax credit, can lower your taxable income and affect your tax withholdings. Reviewing and updating your deductions and credits can ensure accurate withholding amounts.
Lastly, stay informed about changes to tax laws and regulations that may affect your withholdings. Tax reforms, adjustments to tax brackets, and updates to withholding tables can impact the amount of tax withheld from your paycheck.
What Happens If You Overpay?
When the IRS identifies this overpayment during the processing of a tax return, the usual course of action is to issue a refund for the excess amount.
The IRS communicates with taxpayers about overpayments of estimated taxes through the CP24E notice, an official statement that outlines the overpayment on a tax return and the subsequent adjustments made.
Upon receiving the CP24E notice, taxpayers have the opportunity to review the changes and ensure that the final assessment aligns with their financial records.
What to Do With Your Refund
If you do end up overpaying your taxes, you’ll have several different options for receiving this reimbursement from the IRS. You can:
- Apply a portion or all of your refund to the following year’s tax return
- Receive your refund via direct deposit
- Receive your refund in a check
- Purchase Series I Savings Bonds with your refund
Bottom Line
A big tax refund can seem like a financial boon, but it likely means that you’ve overpaid your taxes and forfeited the opportunity to put that extra money to work. To avoid this, consider updating your tax withholdings and revisiting your allowances following major life events.
Tax Season Tips
- SmartAsset has a variety of free tools that can help you prepare for tax season. Our tax return calculator can estimate how much you may owe the government or how much the government may owe you. Meanwhile, retirees can use our RMD calculator to estimate how much they’ll need to take in RMDs this year to avoid a tax penalty.
- A financial advisor can help you get your financial house in order before you file your taxes. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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