As we ease our way into 2017, many of us have money on the brain. With that in mind, I'm here to warn you about a major tax mistake that the vast majority of Americans make: overpaying.
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That's right. Most of us give the IRS way more money up front than we need to year after year. It's estimated that close to 80% of taxpayers wind up with a refund, and while the idea of getting one might seem like a good thing, it's actually a move that could cost you big time.
A common but surprising trend
You'd think more of us would take steps to guard our hard-earned money from the IRS, but clearly, that's not the case. The average American receives a $3,120 refund -- not a small number. Worse yet, those who earn the least are the most likely to overpay their taxes throughout the year. According to IRS data, 84% of workers earning less than $50,000 a year got a refund back in 2012, compared to just 34% of those earning over $200,000. But waiting on a refund can be especially detrimental when you're living paycheck to paycheck.
So why do so many of us overpay our taxes? A lot of it boils down to fear. We're all so worried about owing money each April that we err on the side of caution in advance.
Of course, our collective savings habits don't exactly put us in the best position to deal with an unexpected IRS bill. Roughly 69% of Americans have less than $1,000 in savings, while 34% have no savings at all. It therefore stands to reason that overpaying your taxes might serve as an insurance policy of sorts against owing money and not being able to come up with the cash.
Another reason many of us overpay is that we don't know how many allowances to claim on our W-4s. Every allowance you claim on that form will reduce the tax amount withheld from each paycheck. It's important to get that number right, because if you claim too many allowances, you may end up owing the IRS money. But if you don't claim enough allowances, you'll wind up paying more taxes than necessary during the year. You can use this helpful withholding calculator to see how many allowances you should be claiming and, if needed, adjust your W-4 as soon as possible.
RELATED: The most overlooked tax deductions:
The 10 most overlooked tax deductions
The 10 most overlooked tax deductions
1. State sales taxes
This write-off makes sense primarily for those who live in states that do not impose an income tax. You must choose between deducting state and local income taxes, or state and local sales taxes. For most citizens of income-tax states, the income tax deduction usually is a better deal. IRS has tables for residents of states with sales taxes showing how much they can deduct. But the tables aren’t the last word.
If you purchased a vehicle, boat or airplane, you get to add the state sales tax you paid to the amount shown in IRS tables for your state, to the extent the sales tax rate you paid doesn’t exceed the state’s general sales tax rate. The same goes for home building materials you purchased. These items are easy to overlook. The IRS even has a calculator to help you figure out the deduction, which varies by your state and income level.
2. Reinvested dividends
This isn’t really a tax deduction, but it is a subtraction that can save you a lot of money. And it's one that many taxpayers miss. If, like most investors, you have mutual fund dividends automatically invested in extra shares, remember that each reinvestment increases your “tax basis” in the fund. That, in turn, reduces the amount of taxable capital gain (or increases the tax-saving loss) when you sell your shares.
Forgetting to include the reinvested dividends in your cost basis—which you subtract from the proceeds of sale to determine your gain—means overpaying your taxes. TurboTax Premier and Home & Business tax preparation solutions include a very cool tool—Cost Basis Lookup—that will figure your basis for you and make sure you get credit for every dime of reinvested dividends.
3. Out-of-pocket charitable contributions
It’s hard to overlook the big charitable gifts you made during the year by check or payroll deduction. But the little things add up, too, and you can write off out-of-pocket costs you incur while doing good deeds. Ingredients for casseroles you regularly prepare for a nonprofit organization’s soup kitchen, for example, or the cost of stamps you buy for your school’s fundraiser count as a charitable contribution. If you drove your car for charity in 2017, remember to deduct 14 cents per mile.
4. Student loan interest paid by Mom and Dad
In the past, if parents paid back a student loan incurred by their children, no one got a tax break. To get a deduction, the law said that you had to be both liable for the debt and actually pay it yourself. But now there’s an exception. If Mom and Dad pay back the loan, the IRS treats it as though they gave the money to their child, who then paid the debt. So a child who’s not claimed as a dependent can qualify to deduct up to $2,500 of student loan interest paid by Mom and Dad.
5. Moving expense to take first job
Here’s an interesting dichotomy: Job-hunting expenses incurred while looking for your first job are not deductible, but moving expenses to get to that first job are. And you get this write-off even if you don’t itemize. If you moved more than 50 miles, you can deduct 23 cents per mile of the cost of getting yourself and your household goods to the new area, (plus parking fees and tolls) for driving your own vehicle.
6. Child and Dependent Care Tax Credit
A tax credit is so much better than a tax deduction—it reduces your tax bill dollar for dollar. So missing one is even more painful than missing a deduction that simply reduces the amount of income that’s subject to tax.
But it’s easy to overlook the child and dependent care credit if you pay your child care bills through a reimbursement account at work. Until a few years ago, the child care credit applied to no more than $4,800 of qualifying expenses. The law allows you to run up to $5,000 of such expenses through a tax-favored reimbursement account at work.
Now, however, up to $6,000 can qualify for the credit, but the old $5,000 limit still applies to reimbursement accounts. So if you run the maximum $5,000 through a plan at work but spend more for work-related child care, you can claim the credit on up to an extra $1,000. That would cut your tax bill by at least $200.
7. Earned Income Tax Credit (EITC)
Millions of lower-income people miss out on this every year. However, 25% of taxpayers who are eligible for the Earned Income Tax Credit fail to claim it, according to the IRS. Some people miss out on the credit because the rules can be complicated. Others simply aren’t aware that they qualify.
The EITC is a refundable tax credit—not a deduction—ranging from $510 to $6,318 for 2017. The credit is designed to supplement wages for low-to-moderate income workers. But the credit doesn’t just apply to lower income people. Tens of millions of individuals and families previously classified as "middle class"—including many white-collar workers—are now considered "low income" because they:
• lost a job
• took a pay cut
• or worked fewer hours last year
The exact refund you receive depends on your income, marital status and family size. To get a refund from the EITC you must file a tax return, even if you don’t owe any taxes. Moreover, if you were eligible to claim the credit in the past but didn’t, you can file any time during the year to claim an EITC refund for up to three previous tax years.
8. State tax you paid last spring
Did you owe taxes when you filed your 2016 state tax return in 2017? Then remember to include that amount with your state tax itemized deduction on your 2017 return, along with state income taxes withheld from your paychecks or paid via quarterly estimated payments.
9. Refinancing mortgage points
When you buy a house, you get to deduct points paid to obtain your mortgage all at one time. When you refinance a mortgage, however, you have to deduct the points over the life of the loan. That means you can deduct 1/30th of the points a year if it’s a 30-year mortgage—that’s $33 a year for each $1,000 of points you paid. Doesn't seem like much, but why throw it away?
Also, in the year you pay off the loan—because you sell the house or refinance again—you get to deduct all the points not yet deducted, unless you refinance with the same lender.
10. Jury pay paid to employer
Some employers continue to pay employees’ full salary while they are doing their civic duty, but ask that they turn over their jury fees to the company coffers. The only problem is that the IRS demands that you report those fees as taxable income. If you give the money to your employer you have a right to deduct the amount so you aren’t taxed on money that simply passes through your hands.
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You're missing out on more than you think
The thing to realize about overpaying your taxes is that you're loaning the government money for free. But worse than that, you're compromising your own financial security in the process. We just learned that most of us don't have $1,000 in the bank. If you encounter an emergency you can't pay for because you let the IRS keep your money instead, you could easily end up in debt. Even if you apply your tax refund to that debt later on, you'll have racked up interest charges by then that will end up costing you extra money.
Furthermore, when you hold off on getting the money that's yours, you lose out on the ability to invest that cash or earn interest on it throughout the year. And while today's rates are nothing to write home about, you might as well collect those few dollars in interest instead of letting the government use your money as it sees fit.
A better solution
So let's get back to the fear factor, which is what motivates so many of us to err on the side of overpaying. If you adjust your withholdings, take the extra money from each paycheck, and stick it in a dedicated savings account, you'll get to earn interest on that cash instead of the IRS. Then, if it turns out you do owe some money when you file your return, you can dip into that account, pay the IRS its share, and pocket the interest.
Now some people worry that if they don't pay enough taxes throughout the year, they'll wind up with a penalty on top of what they owe. But often, this doesn't happen. Generally speaking, you can avoid a penalty for underpayment if:
The total amount you owe is less than $1,000, or
You paid at least 90% of the tax you owe for the year, or
You paid 100% of the tax amount from last year's return
So let's say you pay $30,000 in taxes for the year but end up owing another $1,200 when you file your return. Since you're only looking at a 4% underpayment, you shouldn't be charged an additional penalty because you've exceeded that 90% threshold. Furthermore, if you only paid $30,000 in taxes the previous year, you should also be in the clear.
Remember, a tax refund isn't free money; it's your money that you failed to collect all along. You're far better off claiming that cash as you earn it and using it responsibly than loaning it to the government for absolutely nothing in return.
Your filing status can make a big difference in how much income tax you pay. If you make $40,000 a year, for instance, the amount of tax you will pay depends on which filing status you qualify for. The difference in tax rates are significant and can mean the difference between paying up to 15 percent or 25 percent. Your decision to file single, jointly or as head of household will also affect the size of your standard deduction.
The fees for taking SAT, ACT and other college entrance exams are not tax-deductible, but the federal government does allow a number of educational deductions and tax credits. Find out more about these educational deductions and credits and how they can benefit you.