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Making Sense of Your Tax Refund

Many people were surprised that their refund this last tax season was smaller than last year's, or worsethat they needed to cut a check to the US Treasury.

Wasn’t the Tax Cuts and Jobs Act (TCJA) of 2017 supposed to reduce taxes for most people? Let’s take a deeper look to see what’s really going on and what can be done to avoid this issue next tax season.

Tax refunds (or bills) depend on paycheck withholding

Each paycheck has a portion of your earnings taken out and sent to Uncle Sam—a process known as tax withholding. In a perfect world, your total taxes withheld for the year would equal the total tax bill reported on your personal tax return. If that was the case, you wouldn’t get a refund nor would you owe any tax on April 15th.

Unfortunately, changes in income or deductions can make estimating your tax bill difficult. That’s why most people either receive a refund or have to pay a bit extra when they file their tax returns.

Don’t get too excited about getting a refund (or feel bad if you have to pay)

The truth is, both options are neither good nor bad. A refund just means that you over-withheld taxes from your paycheck and paying additional taxes means you under-withheld from your paycheck. 

As exciting as a refund might be, it’s really just the federal government returning the money you overpaid. Think of it as giving the government an interest-free loan: The government gets to use your money and then they return it to you without any compensation—not a great investment.

We generally recommend trying to withhold just enough to cover your tax bill or even pay a little bit extra when you file your return. That way you have more money in your pocket throughout the year, potentially earning some additional interest income.

Ultimately, it’s your total tax bill that matters, not whether you owe or get a refund

The size of your tax refund this year doesn’t tell you if you paid more or less in taxes compared to the previous year.

To truly know how the TCJA affected you, compare your “total tax” for this year to the “total tax” from last year (assuming your total income and deductions were about the same in both years). If your taxable income in 2018 was a lot higher than the previous year’s, you would need to run your 2017 income and deductions through the 2018 tax return to do a true apples to apples comparison of the two years.

While there’s a lot of information on the Form 1040, the following dollar amounts will help you determine your tax liability—and whether you’ll get a refund or owe a bit more on tax day:

  • The total tax due (line 15): what you actually owe in taxes for the year
  • Income tax withheld (line 16): total amount of taxes taken out of your paycheck that year
  • The refund you’ll receive (line 19): called the amount you “overpaid” (i.e. the amount you over-withheld that year) or the amount you owe (line 22): what you under-withheld in taxes for the year

The amount withheld from your paycheck is the key to understanding why your refund may be lower or why additional taxes may have been due. To know if you get a refund or owe additional taxes you simply compare your total tax (line 15) to the total amount of tax withheld (line 16).

If the amount withheld is larger, you overpaid (line 19) and will be eligible for a refund. If the total tax is larger, you under-withheld and will have an amount you owe (line 22) and will have to cut a check for the difference.

Illustration: Back page of the 2018 Form 1040

The IRS replaced Form 1040-A and 1040-EZ in 2018 with this new form.

Why did my refund (or tax due) change so much this year?

In 2018, the IRS changed the withholding tables in an attempt to account for the lower taxes that many people would pay under the TCJA. These tables are used by employers to determine how much should be withheld from your paycheck.

The withholding tables reduced the amount withheld from each pay check during 2018 so that on tax day, the IRS wouldn’t have to issue an enormous number of refunds.

Unfortunately, changing the withholding tables is not an exact science. The unintended consequence of those changes resulted in some people withholding less than expected, which caused their refunds to be lower or in some situations caused them to owe on tax day.

How to prepare for next year

If you want a larger refund next year (not recommended, in our opinion) you can update your Form W-4 and reduce the number of allowances you claim (line 5 on the W-4) or increase the withholding by a specific amount (line 6 on the W-4). If you want a smaller refund, prefer to get your withholding as close to your taxes due, or pay a little bit extra on tax day—you can increase the number of allowances you claim.

We recommend checking on the withholding from your paycheck at least once or twice a year, to stay on track to a targeted withholding amount and to ensure you don’t end up under withholding too much (which could result in penalties). For help determining the amount that should be withheld, use the IRS’ calculator or meet with a tax professional.

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The information provided here is for general informational purposes only and is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, consult with a qualified tax advisor, CPA, financial planner or investment manager. 

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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