This is the last installment in a four-part series looking at the basic structure of a tax return. In the first article, I explained that the standard US individual tax return can basically be divided into four parts: Filing Status (and Exemptions), Income, Deductions and Adjustments, and Credits and Payments. I also explained that the results from these four parts of the return are used in the following equation that ultimately determines your tax liability or refund at the end of the year:
– Adjustment and Deductions
x Effective Tax Rate (determined by your Filing Status)
– Tax Credits and Payments
Your Tax Refund/Balance Due
The first three articles covered everything up to your Income Tax. Now we cover Credits and Payments, which is the section that explains why most people actually get money back when they file a tax return each year.
One important thing I always like to point out is that, contrary to popular opinion, getting a big refund is really not a good thing. Basically, when you get a refund, that usually means you’ve given the government money during the year–typically through paycheck withholding–and now the government is just giving you back the money they’ve been “hanging onto” for you…without interest. My goal with my own return and most of my clients is to actually OWE a little bit of money at the end of the year. You don’t want to owe too much money, because you can get penalized, but owing a little bit of money at the end of the year just means you haven’t been “loaning” money to the government interest-free. (If you want to loan money to the government, you can always buy bonds and get paid interest!)
So this week I want to explain how those payments and credits work to determine your tax liability or refund. Payments are easy to understand. Basically, most people just pre-pay their tax bill throughout the year in the form of withholding from paychecks. Sometimes pensions and certain other payments have money withheld as well. This withholding isn’t the exact tax on a particular payment, it’s just an estimate. At the end of the year, you add up all of those payments, compare it to your actual Income Tax (determined by the formula above), and if you paid too much you get a refund.
It’s kind of like when your credit card is pre-authorized at a gas station. A certain amount of money (I think it’s typically $75) gets set aside in your account as soon as you swipe your credit card. Once you pump your gas, the money that was needed for gas gets transferred out of your account to the gas station. But the money that wasn’t used gets put right back in your account. With a gas purchase, your account is settled as soon as you’re done pumping gas. Tax payments are sort of like a pre-authorization of funds, except it takes a little over a year to settle your account.
Credits work a lot like payments, but with a key difference. Most credits are “non-refundable” credits. A non-refundable credit is a credit that can reduce your tax liability to $0, but not below $0. So if you didn’t have any withholding or other payments during the year, but you had a bunch of non-refundable credits, you could never have a refund. If your tax bill started at $2000, and you had $2500 in nonrefundable credits, you wouldn’t get back a refund for the $500…you would simply reduce your tax to $0. The remaining credit doesn’t do anything for you–although some credits do “carry forward” to the next tax year. So if the $2500 worth of credits all allowed a carry forward, then you would have a $500 credit just waiting to be used in the next tax year. Your credits are always applied before payments. So credits can take your tax liability all the way down to $0, and then if you also made payments, those will be completely refunded. But you won’t ever get back more in a refund than you made in payments…unless…
…you have “refundable” credits. There are a few credits that are considered refundable. The most popular refundable credits are the Child Tax Credit, the Earned Income Credit, and the American Opportunity Credit (for education expenses). There are a few others, but they’re much less common. Refundable credits work more like payments. If you have a tax liability of $2000, and $2500 in refundable credits, you’ll get $500 back from the government…even if you didn’t make any payments at all during the year. People are sometimes confused to find they’re getting a refund that’s more than their entire withholding for the year. When this happens, it’s because they qualify for a refundable credit.
Fortunately, the government applies nonrefundable credits before refundable credits. That means nonrefundable credits will reduce your tax liability until they’re all used up, or you reach $0, whichever comes first. Then the refundable credits are applied, which can take you into “negative tax” territory. I.e. you’re getting a “refund” of money you never actually paid in through withholding.
So this concludes a basic overview of how an income tax return works. You start by determining your Filing Status and whether you can claim any dependents. Then you report all of your income. Next you subtract any adjustments and deductions that you’re allowed to subtract, in order to get to your Taxable Income. Based on your Filing Status, you look up the Income Tax for your level of taxable income in one of the IRS tax tables. Finally, you subtract any credits available to you to get your tax liability as low as possible. If you’re fortunate enough to qualify for refundable credits, your tax liability can actually go negative, meaning the government is actually giving you money. Finally you subtract your payments from your tax liability to determine your refund or remaining balance due at the end of the year.
As you’re compiling all the data to keep your accountant or tax software happy this year, I hope this helps you understand how all that information is being used.