WHY IS MY REFUND SO SMALL!?
WHY DO I OWE MONEY THIS YEAR?!
Taxes are a subject most people only care about one time during the year, April 15th.
For those of you who haven’t read my bio page, I am a CPA. That is a Certified Public Accountant. In other words, I do taxes for a living.
- Why Do I Owe Money This Year?!
- But My Friend Got a Refund This Year!
- Your Refund Is Your Money
- Standard Deduction vs Itemizing
- What Is The $10,000 “SALT” Cap Anyway?
- How Tax Brackets Work
- Tax Loopholes & Secret Deductions
- Some Other Terms You Should Know
This year in particular, more people than ever are paying attention to their taxes due to the Tax Cuts and Jobs Act or TCJA. I have also seen more and more people complaining about the size of their ‘tax return’.
One thing that I am quite aware of is our country’s misunderstanding of how taxes work. I know that this is in part by the tax code being quite complicated and confusing, and a lack of education on the subject. However, for your typical tax filer, it is not as hard as it seems, and I am going to explain in simple terms how it works.
But let’s talk about the biggest problem for tax year 2018, first.
Why Do I Owe Money This Year?!
Let me get this out of the way,
Consider this —
Johnny makes $30,000 every year. Last year, Johnny’s employer withheld $3,000 of federal income tax. Johnny filed his tax return and had a total tax liability of $2,000. Because his withholding was greater than his tax liability, Johnny will receive a $1,000 refund! ($3,000 – $2,000)
Next year, Johnny’s income stayed the same. However, a major tax bill reduced tax rates and increased the standard deduction. Because of the lower tax rates, withholding rates were lowered as well, and Johnny got more money in each of his paychecks. At the end of the year he only withheld $1,400 in federal tax. Tax time comes, Johnny prepares his return and finds out his tax liability is $1,700.
What the heck?! I owe $300? Last year I got a $1,000 refund! I hate taxes!-Johnny
What Johnny failed to remember is that last year his tax liability was $2,000, and this year it’s only $1,700. Johnny got to keep an additional $300 as a result of the lower tax rates.
So, if you are one of the unlucky, or should I say lucky, ones who owes tax this year, don’t reach for the nearest phone to call the IRS and yell at them. You may, and likely are, paying less tax than you did last year.
If your tax situation is the same as last year (2017), grab a copy of your tax return and take a look at line 63. This is your total tax. Compare it to line 15 on the 2018 version of the 1040. If your tax on line 15 is less than line 63, you paid less in tax this year.
But My Friend Got a Refund This Year!
Some things you may want to consider:
- Does your friend work at your job?
- For the same pay?
- With the same W-2?
- And the same withholding?
- Is your friend married or single?
- Do they own a house?
- Did they pay back any student loan interest?
- Do they attend night classes and gets a tuition credit?
- Perhaps your friend is a father/mother with two children?
- Do they contribute to a retirement plan?
- Is their income from investments or W-2 income?
- Do they have a side business?
- Did they pay estimates during the year?
Everyone’s tax situation is different so it is not advisable to compare yourself to anyone else.
Your Refund Is Your Money
Another common misconception is that receiving a refund is the government paying you.
The truth is, it is called a “refund” for a reason. You paid too much of your own money in tax throughout the year and the IRS is simply sending it back to you.
It’s like paying $20 for something that was only $15. When you get the $5 back, it’s not the store paying you out of their own funds, it is just your money they were holding on to.
Ideally, you want your tax due/owed to be as close to $0 as possible.
Standard Deduction vs Itemizing
When preparing your tax return, right before you figure out your tax liability, you have the option of taking the standard deduction or the itemized deduction.
Cool, what does that mean?
The standard deduction is a predetermined amount set by the IRS that you use to reduce your income. In tax year 2018 this amount is $12,000 for single filers, and $24,000 for joint or married filers.
For instance, if you made $52,000 in wages, you only end up paying tax on $40,000 after the standard deduction (52,000 – 12,000).
The standard deduction is great for the majority of people. It is a guaranteed reduction of income which will result in lower taxes.
The itemized deduction is something completely different.
There are certain personal expenses that the IRS says are OK to reduce your taxable income. The major categories for 2018 are unreimbursed medical expenses, state and local taxes, mortgage interest, and charitable contributions.
For instance, if you owned a house with a mortgage, you could potentially itemize (deduct) your real estate taxes and the interest paid for your mortgage that year. If your total itemized deductions are greater than the standard deduction then you would take the more beneficial option.
However, if you live in a state that has high real estate taxes you may have heard people complaining about the $10,000 cap on “SALT”.
What Is The $10,000 “SALT” Cap Anyway?
SALT stands for “State and Local Taxes”. This includes state income taxes withheld from your wages, real estate tax, and personal property taxes.
Why are people so mad about the $10,000 cap? Here’s an example.
Kristie and Joaquin live in NY and each make $125,000 every year, $250,000 total. They also mortgage a house in a nice neighborhood on Long Island.
Combined, their state income tax on their wages for the year ends up being around $16,000. Their real estate taxes are easily $15,000 every year, and they also pay upwards of $19,000 in interest on their mortgage.
In the prior year (2017), before the cap, Kristie and Joaquin would have an itemized deduction of $50,000! (16,000 + 15,000 + 19,000) They would only pay taxes on $200,000 of their wages rather than $250,000.
Under the new law, however, they can only itemize $29,000 (10,000 capped + 19,000). State income taxes and real estate taxes are both considered SALT, therefore they are combined and capped at $10,000. Mortgage interest is added in full.
Therefore, their taxable income is $221,000 (250,000 – 29,000).
This cap will typically only effect high earners in areas with high real estate taxes.
How Tax Brackets Work
If I could choose one other thing that people most commonly misunderstand it’s tax brackets.
The common mistake people make is thinking that when you pass a threshold, all of your income is taxed at a higher rate. Fortunately, that is not how it works.
The IRS uses what are called progressive income tax rates. While this does mean that the more money you make, the higher your tax bracket, it does not mean that all your earnings are taxed at the new rate.
For simplicity, let’s say your taxable income is $82,500. This puts you at the top of the 22% tax bracket.
A good analogy here is buckets. To figure out your tax, you need to split up all your income into these buckets. Your first and smallest bucket can hold $9,525. Once you fill up that bucket, you start filling the next one, which holds $29,175, the next $43,800. You take these buckets to the IRS and they say –
Ok, your first bucket we are going to tax at 10%. Your second bucket we will tax at 12%. The third, 22%. Therefore your total tax is $14,089.-The IRS
If we had just taken a straight 22% of the income we would have a tax of $18,150. Instead, with a progressive system, we have a tax of $14,089. If you take your tax, $14,089, and divide it by your income, $82,500, you get what is called your “Effective Tax Rate“.
In our case, that is about 17%.
A person’s “Marginal Tax Rate” is a their highest tax bracket. For instance, someone making $82,500, their marginal tax rate would be 22%, that is the highest bracket that their income extends to.
Tax Loopholes & Secret Deductions
Ooooh, yes, here comes the GOOD STUFF. What’s the trick, Chris? Can I take some ‘extra deductions’ if you know what I mean? Wink, Wink.
If you are reading this article, there are no secrets, no loopholes, no ‘deductions’ or ‘write-offs’, that even the most expensive tax software will get you. There is the Tax Code, and it is very thorough. Any ‘trick’ you think you’ve found is already known about, and there is probably a clause that will stop you from doing it anyway.
What there IS, however, is smart tax planning. Things that anyone can take advantage of such as contributing to a 401k, or Traditional IRA to reduce your taxable income.
The truth is, the simpler your tax return is, the less planning there is to do. Your tax is your tax and that’s about it. Once you begin to have investments and other assets, planning strategies could be used to help reduce your tax liability.
Some Other Terms You Should Know
Tax Return – Probably one of the most misused terms. The “tax return” is the form you fill out and file. It is the document you likely know as the “1040”. It is not the money you get back from filing.
W-2 – This is the form you get from your employer at the end of the year detailing how much money you were paid and how much taxes were withheld.
W-4 – This form is given to new employees so the company knows how much tax to withhold from your paychecks. The lower the number, called allowances, the more that is withheld. Your allowances number is not set in stone, it can be changed if you request it with your employer.
Withholding – When you get paid some of that money goes to “Federal Income Tax”, sometimes abbreviated as FIT. Some of it goes to Social Security and Medicare, known as FICA tax. Taxes that are taken from your paycheck are called withholding’s. Your withholding is based on that form “W-4” you filled out when you started your job. You likely put a 0, 1, or 2.
Taxable Income – The amount of your income that is subject to tax.
Tax Liability – Your “tax liability” is the calculated amount of tax you are liable for based on how much taxable income you had during the year. This is not to be confused with tax due.
Tax Due – This is the result of not paying in enough tax during the year. You owe tax if your withholding is less than your tax liability.
Refund – A “refund” is the money you get back after filing a tax return if your withholding is greater than your tax liability.
Even though this post may simplify how taxes work, as mentioned, everyone’s situation is different.
Leave a post below or send me an email (firstname.lastname@example.org) if you have a question and I will do my best to answer it.
I hope you learned something!