Is It Better To Owe, Break Even or Get a Refund: Which Is the Best Tax Strategy?
Paying taxes can often be frustratingly unpredictable when figuring out the right exemptions or extra amount to withhold on your W-4 form, calculating the right quarterly amounts for estimated taxes, and wondering if you’ll break even, owe money or get a refund.
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When it comes to the right tax strategy, there’s no right size that fits all solution — each tax return scenario offers advantages and drawbacks.
Tax refunds aren’t all that they seem to be
While it might seem like a huge bonus to get a tax refund every spring, you’re actually just getting your own money back. This means you paid too much into the tax system in a given year and the government is returning it back without any penalty. Some have compared it to giving the government an interest-free loan.
As of February 2023, the IRS has processed 16.7 million tax returns and paid out $15.7 billion in refunds with the average taxpayer receiving around $1,963. But rather than getting that nearly $2,000 lump sum that may be spent on indulgences (about 10% of people apply it towards travel or “treating” themselves), correctly calculating tax withholdings could have netted almost $200 extra per month that could have been applied to regular expenses.
However, some people do like getting the large deposit with their tax refund to use toward smart financial moves, according to a GOBankingRates poll, such as putting it in savings (25.75%), paying bills (21.16%) or paying off debt (19.66%). In those scenarios, it has a big benefit, especially for those who have a hard time saving throughout the year.
Breaking even on taxes is hard to do, but has benefits
Trying to net zero for your annual tax burden is a proverbial Goldilocks strategy — not too much paid to the IRS, not too little paid, and getting the withholdings or quarterly taxes just right. It can be difficult to keep up every year as tax brackets and laws change, requiring an update to your whole strategy from the year prior.
The IRS has very helpful withholding calculators that may help you get a better ballpark figure, and a certified tax professional will aid you even more in computing a good average. If you’re changing jobs throughout the year or have qualifying life events such as taking an early withdrawal from retirement savings or selling assets, you might want to recalculate to make sure you’re on track for the rest of the year.
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If you’re able to get pretty close to zero (not owing too much and not receiving a substantial tax refund), this may be the best of all scenarios. It allows you to maximize your take-home pay and have more funds to work with each month while ensuring you don’t have a large bill from the IRS come April.
“The best strategy is breaking even, owing the IRS an amount you can easily pay, or getting a small refund,” Clare J. Fazackerley, CPA, CFP, told Finance Buzz. “You don’t want to owe more than $1,000 because you’ll have an underpayment penalty of 5% interest, which is more than you can make investing the money. Owing the IRS more than you can easily pay results in extended payment agreements with interest and penalties.”
Owing money may be even better than getting a refund
It might be hard to believe, but owing a small amount to the IRS each year could be better than receiving a refund. While you won’t want to have a bill for more than $1,000 due to the 5% interest penalty, a three-figure IOU won’t come with any tacked on amounts and also means you didn’t overpay, interest-free, to the government.
This scenario may also have a benefit throughout the tax year in providing some extra cash flow that could be needed for health events, home repairs or coping with current inflation. And the good news is that if you can’t afford to pay the full amount come April, the IRS usually gives some leeway for filing an extension and can institute a payment installment agreement with minimal penalties for small amounts owed.
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Taxes 2023: Changes To Note if You Have Household Employees
If you took on a side gig for the first time in 2022, you should also be prepared to owe. Any work that is contract-based or freelance will usually not have taxes withheld by the employer, putting the responsibility on you to pay quarterly estimates. Usually those estimates are calculated by looking at the average of income taken in from the year prior. So, if 2022 was your first year, you might not have paid enough into the IRS over the course of the year. Fortunately, you can use your 2022 earnings to figure out what to start paying over the course of 2023.
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This article originally appeared on GOBankingRates.com: Is It Better To Owe, Break Even or Get a Refund: Which Is the Best Tax Strategy?
