Focusing on a Tax Refund? Do Some Planning Instead

Dear Carrie,

When I did my taxes last year, I wound up owing a lot to the IRS. A friend at work mentioned she got a huge refund. Can I do something to get a refund too?

—A Reader

Dear Reader,

Tax season always brings a host of questions from readers. Mostly they boil down to "How can I pay less in taxes?" or "How can I get a bigger refund?" But these are two very different questions. Here's why.

Tax refunds vs. how much you pay

Getting a refund doesn't mean you're paying less in taxes. A tax refund simply means you had too much withheld and, in effect, gave the government a zero-interest loan the prior year. In the same way, if you have to pay taxes when filing, it doesn't mean you're paying more. It just means you had less withheld than you owed the prior year. 

So rather than focusing on a refund, your main focus should be on your total tax bill and what you can do to potentially reduce the taxes you pay. Here are some suggestions.

Check your withholding

To make sure you're not over or under paying, check to see if the right amount of taxes is being withheld from your income. You can do this with the IRS's Tax Withholding Estimator. It's important not to under withhold by too much as that can trigger a penalty as well as interest. Be sure to account for bonuses, investment income, and other income sources like rental income to ensure you're withholding the right amount. 

If you don't have taxes withheld, for instance if you're self-employed, an independent contractor, or have significant income from sources other than wages, you should be making quarterly estimated tax payments to the IRS to avoid penalties and interest.

Understand deductions

Deductions reduce the amount of income subject to tax. For some filers, itemizing deductions such as mortgage interest makes sense. But because of recent increases in the standard deduction ($12,550 for single taxpayers; $25,100 for married filing jointly for 2021), it's more practical for most filers to take the standard deduction rather than itemizing. (Good news for student loan borrowers: A portion of your interest on student loans can be deductible without itemizing.)

But whether or not you itemize, deductions aren't the only way to get a tax break.

Maximize contributions to tax-advantaged savings accounts

One surefire way to lower your tax bill is to contribute to tax-advantaged accounts. For instance, tax-deductible contributions to traditional IRA, 401(k), 403(b), and 457(b) accounts can reduce your taxable income dollar for dollar. Roth IRA and Roth 401(k) contributions don’t provide a tax deduction upfront, but still provide tax-deferred growth and the potential for tax-free earnings for qualified distributions after age 59½. 

If you have access to a Health Savings Account (HSA), you get the advantage of 100% deductible contributions, tax-deferral, and tax-free distributions for qualified health care expenses now and in the future. This can be a great tax move. 

Plus, individuals 50 and older can make annual "catch up" contributions of $1,000 to an IRA and $6,500 to 401(k)/403(b)/457(b) plans. Individuals 55 and older can make $1,000 annual catch up contributions to an HSA. 

Other tax-advantaged accounts like 529 College Savings Plans and Flexible Savings Accounts can also help you save on taxes while saving for other goals. 

Get (tax) credits

Tax credits can be even more valuable than tax deductions because they offset what you may owe in taxes dollar-for-dollar. There is a wide range of tax credits available to all types of taxpayers. Some credits may not apply to you or may be phased out based on your filing status or income, but it's worth your time to do some research. Here's a list of just a handful of important (but often overlooked!) tax credits:

• Earned Income Tax Credit—This is a tax break for lower-income families with children. The average amount of EITC received nationwide was about $2,400 in 2020.
• Child Tax Credit— Expanded by the 2021 American Rescue Plan Act (ARPA), this credit is up to $3,000 per child for children 6 through 17 and up to $3,600 for children under 6.
• Child and Dependent Care Credit—Also expanded for 2021 by ARPA, this credit is up to $4,000 for each qualifying child or dependent or $8,000 for two or more. 
• Retirement Saver’s Credit—Up to $1,000 ($2,000 for joint filers) in government "matching funds" helps low earners save more in a 401(k), 529 ABLE or IRA. 
• American Opportunity Credit (AOTC) and Lifetime Learning Credit (LLC)—Designed to help with the cost of higher education, the AOTC is up to $2,500 per eligible student; the LLC is up to $2,000 per tax return. You can claim both AOTC and LLC credits on the same return—but not for the same student or the same qualified expenses. 
• Premium Tax Credit (Affordable Care Act)—If you purchase health insurance through one of the exchanges created by the ACA, you may qualify for this tax credit to lower health insurance costs. 
• Residential Energy Credit—If you're a homeowner who invested in solar panels or other energy efficient upgrades to your home, you may qualify for a credit equal to a percentage of the upgrade's cost.

Consider these strategies

Besides the opportunities discussed above, the following strategies may also help lower your taxes:

• Bunching deductions—Certain deductions like charitable contributions and medical expenses are permitted if you itemize them. By "bunching deductions" in a particular year, rather than spreading them over multiple years, you may increase the likelihood of being able to itemize these costs. 
• Tax loss harvesting—If you have investments in taxable accounts that have lost money, you may be able to use those losses to offset capital gains. Plus, you can deduct up to $3,000 of any remaining losses to offset ordinary income each year—and carry additional losses into future years. 
• Gifting—Giving appreciated stock or income-producing assets to charities or individuals in a lower tax bracket may save on taxes and allow you to gift more. 

As good as a tax refund may feel in the moment, that's not a sign you paid less overall. Instead of focusing on a refund, take the time to do some planning, making the most of tax-advantaged accounts as well as deductions and credits. Talk with a tax advisor for more specific advice and details. And once you've planned your strategy, consider E-filing for a quicker response from the IRS.

Have a personal finance question? Email us at askcarrie@schwab.com. Carrie cannot respond to questions directly, but your topic may be considered for a future article. For Schwab account questions and general inquiries, contact Schwab.