While preparing a client’s tax return the other day, the result was that he had nearly a $5,000 refund coming. Often when we have a large refund coming we think “Nice! It’s like an unexpected gift!” But as you’ll see below, this is not a gift – it’s actually costing quite a lot in taxes in this particular case.
Naturally, as in most cases like this, I reviewed his income sources and withholding to see if there was anything obvious that we could change for him that would make his withholding more efficient.
| You see, it’s most efficient to have no refund at all from the IRS when your taxes are prepared. In fact, owing an amount up to just south of $1,000 is the most efficient outcome. This is because you’re getting the use of that grand of income tax throughout the year with no cost. In other words, through the year the IRS has loaned you nearly $1,000 and charged no interest.
The $1,000 amount is important here – because if you have more than $1,000 owed in taxes two or more years in a row, the IRS begins to get annoyed about it. As a result, they assess a penalty for underpayment of tax when you owe too much year after year. But if you keep the amount owed down to $1,000 or less, no harm. |
So anyhow, I started reviewing my client’s sources of income and withholding, and here’s what I found (income amounts adjusted for annual increase where applicable):
| Source | Income | Withholding |
| Interest | $550 | $0 |
| Dividends | $550 | $0 |
| IRA Distributions | $28,000 | $4,000 |
| Pension | $13,000 | $2,000 |
| Social Security | $39,000 | $4,000 |
| Totals | $81,100 | $10,000 |
Projecting income tax for 2017, we found the following:
| Interest & dividends | $1,100 |
| IRA Distributions | $28,000 |
| Pension | $13,000 |
| Taxable Social Security* | $20,960 |
| Adjusted Gross Income (AGI) | $63,060 |
| Standard Deduction** | $15,200 |
| Personal Exemptions | $8,100 |
| Taxable Income (AGI minus Std Ded & Exemptions) |
$39,760 |
| Tax | $5,031.50 |
| Withholding | $10,000 |
| Refund or (payment) | $4,968.50 |
Now, reviewing the withholding amounts, it’s obvious that there are three places to reduce excess withholding to rectify this situation. One could stop the withholding altogether from the Social Security benefits, for example, and the result would be a refund of $968.50 – giving him access to $4,000 of his refund throughout the year. In other words, instead of $2,916.67 each month, his and his wife’s SS benefits could be $3,250.
Likewise, he could eliminate the $2,000 of withholding from his pension. This single move would bring down his refund to $2,968.50, bumping up his pension payments to $1,083 per month instead of $916.67.
Lastly, he could reduce his withdrawal from the IRA by $4,000, which would begin to make other changes in his overall tax situation. He’s making the withdrawal in that amount by choice in order to cover his income needs. So truly what he needs from the IRA is $2,000 per month, since he needs income of approximately $5,800 a month for his living expenses. Below is the outcome if he reduces his overall IRA withdrawal by the amount of the withholding, $4,000 (since it’s all excess withholding).
| Interest & dividends | $1,100 |
| IRA Distributions | $24,000 |
| Pension | $13,000 |
| Taxable Social Security* | $17,560 |
| Adjusted Gross Income (AGI) | $55,660 |
| Standard Deduction** | $15,200 |
| Personal Exemptions | $8,100 |
| Taxable Income (AGI minus Std Ded & Exemptions) |
$32,360 |
| Tax | $3,921.50 |
| Withholding | $6,000 |
| Refund or (payment) | $2,078.50 |
When we reduce his IRA distribution by $4,000 ($333.33/month, all of which was being withheld unnecessarily), his taxable Social Security income adjusts*. Now his taxable SS is only $17,560. So reducing his IRA withdrawal by $4,000 and thereby reducing his withholding by $4,000 results in a total tax of $3,921.50 – and he still has a refund coming in the amount of $2,078.50!
Keeping in mind that he has an income requirement of $5,800 per month, we make another adjustment to his withholding – we eliminate the $2,000 of withholding from his Pension payments. By doing this we can reduce his IRA withdrawals by an additional $2,000 per year.
| Interest & dividends | $1,100 |
| IRA Distributions | $22,000 |
| Pension | $13,000 |
| Taxable Social Security* | $15,860 |
| Adjusted Gross Income (AGI) | $51,960 |
| Standard Deduction** | $15,200 |
| Personal Exemptions | $8,100 |
| Taxable Income (AGI minus Std Ded & Exemptions) |
$28,660 |
| Tax | $3,366.50 |
| Withholding | $4,000 |
| Refund or (payment) | $633.50 |
You guessed it, this drops his taxable Social Security again. Only $15,860 is now taxed, and his total tax is down to $3,366.50 – and he still has a refund of $633.50 coming!
Taking it a step further, we can reduce the withholding on his Social Security payments by $1,000 – so that now he has only $3,000 being withheld. Covering his income need only requires a withdrawal of $21,000 from his IRA – which adjusts his taxable Social Security down, so that only $15,010 is taxed. His resulting tax bill is now only $3,089. When he files his return, he’ll owe a total of $89.
| Interest & dividends | $1,100 |
| IRA Distributions | $21,000 |
| Pension | $13,000 |
| Taxable Social Security* | $15,010 |
| Adjusted Gross Income (AGI) | $50,110 |
| Standard Deduction** | $15,200 |
| Personal Exemptions | $8,100 |
| Taxable Income (AGI minus Std Ded & Exemptions) |
$26,810 |
| Tax | $3,089 |
| Withholding | $3,000 |
| Refund or (payment) | ($89) |
Let’s try one more step: drop the withholding on Social Security benefits to $2,000. Or easier, leave the pension withholding as it is and eliminate withholding on the SS payments. Because of this, we can reduce the IRA withdrawal to a total of $20,000. This drops the taxable Social Security down to $14,160 and his tax down to $2,811.50! After his withholding of $2,000, he will owe $811.50 in tax.
| Interest & dividends | $1,100 |
| IRA Distributions | $20,000 |
| Pension | $13,000 |
| Taxable Social Security* | $14,160 |
| Adjusted Gross Income (AGI) | $48,260 |
| Standard Deduction** | $15,200 |
| Personal Exemptions | $8,100 |
| Taxable Income (AGI minus Std Ded & Exemptions) | $24,960 |
| Tax | $2,811.50 |
| Withholding | $2,000 |
| Refund or (payment) | ($811.50) |
Throughout this example, the net amount of income received each month remains roughly the same. In every instance there is approximately $5,800 per month to live on. In the end though, he’s paying $2,220 less in taxes and the IRS is loaning him $811.50 interest free through the year. That’s a reduction of 44% in taxes!
So – when you see a high refund on your tax return, don’t look at it as a “gift”. It’s a pretty expensive gift if that $4,968.50 has cost you an extra $2,220 in taxes!
* Taxation of Social Security is very complicated. See the article How Taxation of Social Security Benefits Works for more details.
** The client in question and his spouse are both over age 65, so their Standard Deduction is increased to a total of $15,200.