Well, so now we get to income taxes. Since I am in the US this post is specific to same. None of this should be considered accounting/tax advice as everyone's situation is different.
I want to explain the difference between what one's tax is and refunds/amounts due. I want to do this as I have found a lot of people don't understand the difference. This came up recently on (of all things) a discussion group about a comic strip.
In a prior discussion I mentioned that under the new income tax laws that came into effect last year (for 2018 income taxes filed in 2019) I had a client who had a low enough income (US$35,000) that they had not had to pay income taxes for several years and under the new tax law they had to pay income taxes. Someone posted back to me that I must not be a good accountant as his brother in law always gets a large refund so the people that I wrote about should also have gotten money back. I posted back to him explaining that having to pay taxes is not the same as whether or not one gets a refund.
If one works for someone income (and other) taxes are subtracted from one's salary before one gets paid their net taxes. One's employer will is required to withhold these taxes from your salary and pay them to the various tax authorities for you. In addition to Federal income tax and Social Security/Medicare taxes, different US states have different taxes that have to be withheld – some states have their own income tax, some cities or other municipalities also have their own income or other taxes, then depending on the state there may be other items that are required to be withheld from your income some examples are – unemployment taxes, disability insurance, family leave insurance, etc. These are not taken out of your income by the government (as someone else thought on a different group that I am on - “The state did not take enough income tax from my salary and I had to pay the rest”. There are charts – when I started they were all printed charts, but now that may be part of a payroll program or other software – that tell employers how much to withhold and for what depending on one's income.
Now these amounts are based on what someone making making that income for the number of people they say are their dependents and their self (and if they are married filing jointly, married filing separately, single or an unmarried head of household who use the standard deduction will owe for income taxes at the end of the year when they file their return. It does not take into account any other income the person has – if one is married and filing a joint return the fact that the other spouse also has income and when the return is filed the two incomes will added together and raise the total amount on which taxes are being paid so that one will owe more,, is not taken into consideration – nor is high itemized deductions, as well as other factor which affect one's tax for the year when the return is filed.
If one does not work for someone for wages they also have to prepay their income taxes in quarterly estimated (as in I estimating what my income tax will be) taxes which serve the same purpose as withholding taxes - the person is paying the estimated taxes to the government(s) themselves instead of their employer doing so. Sometimes one has to pay estimated taxes in addition to the amounts withheld by one's employer if one normally owes taxes when they file their returns. Follow me so far?
Now these amounts withheld or paid as estimated taxes are amounts that you have paid in anticipation of what your actual income tax will be when your return is prepared. They are just advance payments on your taxes.
Person A (using ridiculously small numbers) had $1000 withheld from salary for Federal income taxes.
Person B had $2000 withheld from their salary for the same amount of income for same.
Person C who is self employed has paid estimated taxes of $500 towards their income taxes on the same amount of income.
Person D who is also self-employed did not know that any estimated taxes had to be paid and paid nothing towards his income taxes in advance.
Then it is time to file income taxes.
All four people in the example calculate that their income tax is $1000 – which is a relatively low amount, but let's not go into large numbers or this will seem like school.
Person A has paid their income tax in full with their withholding and exactly (very rare in real life) and owes no more income tax and is not entitled to any refund of their withholding taxes as their tax is $1000 and they had $1000 withheld.
Person B overpaid their income taxes as they had $2000 withheld – perhaps they itemized and had more deductions than the standard amount. Person B is entitled to a refund of the $1000 they overpaid - $2000 withheld less $1000 tax actually owed results in a $1000 overpayment to be refunded.
Person C underpaid their income taxes as they only paid in $500 in estimated taxes and they owe $1000. Person C has to pay $500 in additional taxes as they did not prepay enough in estimated taxes.
Person D since they have not paid anything towards their income taxes owes the entire amount of $1000.
Does that make sense to you? All four people paid the same exact amount of income taxes it is just when they paid it that varies. So someone who gets a refund may actually be paying more in actual income taxes than someone who owes money at the end of the year – or the same amount as the other person or less than the other person. It is the actual amount of income tax- and not when one pays it that sets what the tax is for that person. So if you have to pay taxes and the person next to you at work (or your friend) gets a refund that does not mean that their income taxes are less than yours – they may be paying more in income taxes than you - or the same or less - the amount one owes or is due as a refund on their income tax return does not say how much tax the person owed compared to you.
Now this is all a bit simplified – if one underpays one's tax one may owe penalties or interest for underpaying their tax – one has to have prepaid 90% of their income tax or will owe same unless, in most cases, the amount they paid in advance is equal or greater than the amount that their income tax was the year before.
Oh – and if you overpay your tax on purpose - remember you have made an interest free loan to the government as they have the use of your money from when you pay it to them (by withholding or estimate) until they refund the amount they owe you.
THOUGHT OF THE WEEK -
It is the amount of income tax one actually owes in total, not the amount one gets as a refund or one owes when their income tax is due which is one's actual income tax for the year.
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