If you get a tax refund, it means you overpaid your taxes for the year. If you got a refund from your state, in most cases, it sends you a check or makes an electronic deposit of the tax overpayment refund, but you can also choose to have it used for future tax payments. Although this is not required, it may be helpful if you expect your taxes to increase significantly and don't trust yourself to save the money or if you're self-employed and pay quarterly estimated taxes. The same logic applies to federal tax overpayments.
Applying your tax refund to your next tax return is an option which may help you offset your tax bill in the future. That being said, you may wish to reduce your current tax withholdings which will allow you to utilize more income during the year rather than accruing a large refund during filing.
Overpayment of State Taxes Applied to Next Year
The reason you get a tax refund, especially if it is a large one, is that you are withholding too much from your paychecks. Your employer bases your state withholdings on a form similar to the federal W-4 form. Usually it's called the "Employee’s Withholding Allowance Certificate." You choose your allowances based on your filing status. If you're single with no dependents, your allowance is typically zero, but if you're married and have multiple kids, you may choose an allowance for yourself, your spouse and each of your kids.
The more tax allowances you take, the less your employer withholds from your paycheck. However, if you take too many, you end up with a tax bill and possibly penalties at the end of the year. State underpayment penalties usually are similar to the IRS's policy, which result in a penalty if you end up withholding less than 90 percent of your current taxes or 100 percent of your previous year's taxes. There is no IRS overpayment penalty if you pay too much.
However, a large refund means you didn't take enough allowances and overpaid your taxes. You lost the use of your hard-earned money for the entire year. This may sound like a safe way to handle taxes, but you're losing the opportunity to increase the value of your refund dollars in an interest-bearing savings account or investment of your choice.
Options to Optimize Your Tax
If you foresee owing taxes because you're losing some of your tax deductions or your filing status is changing, you can use your refund to cover the expected tax increase. However, you can also adjust your withholdings anytime by submitting a new allowances form to your human resources department. That way, you can go ahead and get your refund now, use it or put it in a savings account, while having the proper amount taken from your paycheck during the course of the next year to cover any tax increases. If you're self-employed and concerned about making your first quarterly estimated tax payment, you can also use the refund dollars for it.
While you probably want to withhold just enough to cover your taxes, this is not always possible. Sometimes, if you take no allowances, you have a refund, but if you take one allowance you end up owing money. It's OK to play it safe and take no allowances if you know you're not likely to save the money to make the tax payment. However, if you're taking way too few allowances and getting way too much back in the form of a refund, you may want to adjust your allowances to reduce your refund.
2018 Federal Tax Law Changes
As of 2018, federal tax bracket marginal tax rates are generally decreasing and the standard deduction is increasing. Withholding tax tables for employers are also updating, but this may mean that if you pay estimated tax, such as if you're self-employed or have large investment earnings, you may end up overpaying.
You may want to adjust your tax payments accordingly to avoid overpaying your taxes under the new tax law.
Some states are also adjusting their tax policies or have tax policies that may be affected by the federal changes. Consult your state's tax agency or a tax preparer or accountant to learn how you may be affected.
2017 Tax Law
Under 2017 tax law, tax rates are generally higher than in 2018 while the standard deduction is lower. If your taxes may go down in 2018, this may affect your decisions on what to do with any tax overpayment from 2017.
- 20 Something Finance: 3 Reasons why Tax Refunds are Bad & how Allowances can Help
- North Carolina Department of Revenue: Employee’s Withholding Allowance Certificate
- TaxSlayer: Apply Overpayment to Next Year's Taxes
- IRS: Understanding Your CP268 Notice
- Internal Revenue Service. "Topic No. 753 Form W-4 – Employee's Withholding Certificate." Accessed Sept. 22, 2020.
Chris Brantley began writing professionally for a financial analysis firm in 1997. From 2000 to 2004, he worked as a financial advisor, specializing in retirement planning and earned his Series 7, Series 66 and insurance licenses. Brantley started his full-time writing career in 2012 and has written for a variety of financial websites, including insurance, real estate, loan and investment sites. He holds a Bachelor of Arts in English from the University of Georgia.