I recently had a conversation with a prospective client and he said, “Will you get me a better refund than my accountant last year?” This person was asking the wrong question.

The question stems from a misconception many Americans have on how our tax system works. A tax refund is not an indication of paying less in taxes, it is only an indication that you paid too much in advance for your tax liability. Allow me to explain…

The US Tax System is a pay as you go system. As you earn money, you have a responsibility to pay taxes on the money earned. Typically, if you have a job with earnings reported to you on a W2, then taxes are withheld every paycheck. If you are a business owner or independent contractor then you are obligated to make quarterly estimated tax payments, 4 times each year.

Herein lies the source of the confusion and the inherent problem. Due to circumstances that can change throughout the year and each person’s eligible tax credits and family tax situation, the actual amount in taxes owed for the year are not actually determined until you prepare your tax return 2-4 months after the year is over.

Therefore, all taxes paid through your paycheck withholding or estimated taxes are simply deposits with the government to settle your ultimate tax bill. In other words, a refund simply means you gave them too much money during the year and if you owe money, it means you didn’t withhold or estimate enough during the year.

The real measure of how well you are doing from a tax perspective is if you calculate your effective tax rate or the amount of tax you had to pay divided by the amount of income you had. The lower the rate, the more tax efficient you are.

So, is a tax refund good or bad?

This depends on a few things. First, was it done on purpose? Some people lack the discipline to save and find overpaying their taxes a good way to ensure they have the funds for a family vacation in the spring via their tax refund. From a financial advice perspective, why would you give the government a free loan? If your household budget is tight all year but you get a $6,000 refund at tax time, how much easier would life had been if you had $500 additional income each month?

The good news is you get to decide.

If you need help correcting your situation of consistently overpaying or underpaying your taxes, then we can help.