Few people pay exactly the correct amount of income tax during the year. When filing annual returns, it is common to find underpayments (resulting in tax payments due) or overpayments (resulting in refunds or application to future years). Oftentimes, refunds are the result of excessive income tax withholdings from routine paychecks.
A discussion of the benefits and drawbacks of tax refunds follows.
Benefits of Tax Refunds. Obviously, receiving a check from the federal government can be a satisfying experience. Few people would turn down such a proposition. In addition, federal tax refunds are not taxable income in the year received. As such, refunds received from excessive payroll withholdings represent a form of forced savings that can be accessed annually upon filing income tax returns.
Drawbacks of Tax Refunds. On the flip side, paying in extra income tax withholdings can be compared to making an interest-free loan to the IRS. Waiting until March or April of each year to gain access to hard earned wages can feel like a lifetime. This strategy can be especially unappealing when it arises inadvertently, which can be the case in years when taxpayers experience major life events (such as marriage or birth of a child).
Income Tax Withholding Adjustments. Depending on individual risk tolerance, some taxpayers prefer the forced savings approach that results in tax refunds at year end. If, however, you feel that your payday receipts are being incorrectly limited by excessive withholdings (and resulting in large tax refunds), you may be able to reduce tax withholdings and increase net pay by preparing IRS Form W-4, Employee’s Withholding Allowance Certificate and submitting it to your employer