Adjusting withholding can sometimes produce a surprise.

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