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Higher Tax Refund v. Lower Tax Liability

Higher Tax Refund v. Lower Tax Liability - Which one is better?

Many people use their anticipated tax refund as a type of "forced savings." If you're not disciplined enough or don't have a high enough income to put anything in savings during the year, your federal tax refund may serve well as a form of savings for large purchases. But is this really the best way to go?


Big Refund Equals Lost Interest

If you try to maximize your refund during the year you're losing out on additional money. The IRS is basically holding money you could be earning interest on. The IRS doesn't pay you interest on money you've overpaid toward your taxes. So, you are basically giving the government an interest-free loan.

At the beginning of the tax year, use a free calculator to determine approximately what your tax liability will be at the end of the year. Adjust your withholding accordingly so you're not overpaying into the system. Take the additional money in your paycheck and have it automatically deposited into an interest-bearing savings account. Not only will you now make money on those savings but you will have it immediately available to you in case of an emergency.

If you're using your state taxes as another way of getting a bigger refund, beware. Many states are in a financial crunch themselves and are delaying processing of refunds more and more often. Again, you're better off determining what your state tax liability will be and adjusting your state withholding accordingly.

Just be sure you don't reduce your withholding so much that you end up owing taxes at the end of the year. Be as accurate as possible in your calculations and leave yourself a small cushion in your withholding. Also, re-evaluate your withholding if your level of income changes during the year.


Lower Your Tax Liability

The bottom line here is that you should be more concerned about the tax liability line on your tax return than the refund or balance due line. There are many ways to reduce your tax liability without much effort.

First, work to reduce your AGI or Adjusted Gross Income. This is basically the total of all your income minus any deductions and credits. You can reduce your AGI by contributing to an IRA or 401k. This money goes into that account tax free and builds interest for you over the years as you reach retirement. Not only is this money reducing your AGI but it's another way for you to save. Student loan interest payments, tuition and expenses, alimony and other items also reduce your AGI, so look for ways to bring this amount as low as possible.

Second, look at itemizing your deductions. Compare the amount you can deduct by taking the standard deduction to the amount you'd get by itemizing. An online tax preparation site will ask you the pertinent questions to add up your itemized deductions and then give you the one that will save you the most money. Deductions that are often itemized include health care expenses, personal property taxes, mortgage interest, state and local taxes you've paid, gifts to charity, unreimbursed employee expenses and many more.

Third, take advantage of as many credits as you can. In 2009, there were numerous new credits available through the Economic Recovery Act that will still be available for the 2010 tax year. And there are credits that are always available, like the Earned Income Credit, Child Tax Credit, and many more. Take the time to seek out these credits. It may take more time to do your taxes but you'll be getting paid for that time in terms of a lower tax liability and more money in your pocket.

The bottom line is reducing your tax liability is a better idea than trying to increase your tax refund.
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