So you went the DIY route and your tax refund is lower than you expected. Your first step is likely to verify that the information you entered into your tax software is correct. If it is, you may have fallen victim to one of several common scenarios that lead to tax refund surprises. 

Reasons Why Your Tax Return is Lower Than Expected

Scenario 1 – Multiple Jobs

Picking up a second job can reduce your tax refund due to the way income tax gets calculated. At the end of the year, your combined income from both jobs may put you in a higher tax bracket than counting each job separately.

Let’s look at an example. Pretend your job pays $25,000 a year. Every week your boss deducts taxes from your paycheck to cover the tax liability on that salary. Money is a little tight, though, so you pick up a second job that pays $10,000 a year. Your boss at job 2 also deducts taxes from your paycheck. Sounds good so far.

Here’s the problem. Boss number 1 is withholding taxes on your $25,000 salary. Boss number 2 is withholding taxes on your $10,00 salary. But when you combine your income from both jobs on your tax return, you actually made $35,000 total. This may put you into a higher tax bracket than either salary did when considered on its own.

Scenario 2 – Too Few Withholdings

Getting a small tax refund because of too few tax withholdings is actually a good problem to have. It means that you have your withholding properly matched to your income. Here is what we mean.

When you start a new job, your employer will ask you to fill out a W-4 form. On this form, you tell your employer how many dependents you have for tax withholding. If you’re single, you’ll likely claim 1 withholding exemption just for yourself. If you’re married and have a child, you’ll likely claim 3: yourself, your spouse and your child. The more exemptions you take, the less tax your employer will take from your paycheck throughout the year.

w4 withholdings

Increasing your deductions decreases your tax withholding and increases the amount of your weekly paycheck. This puts more money in your pocket during the year, but it does so by reducing your tax refund later. If you want a bigger refund, you need to claim fewer deductions on your W-4.

Although lowering your withholding is a viable way of getting a bigger refund, exercise caution if you go this route. What you’re essentially doing is asking your boss to withhold extra money from your check every week so you can get it back at the end of the year. Doing so essentially uses the IRS as a bank, and this practice is frowned upon. There are two reasons for this.

One, the IRS doesn’t really want you to use them as a savings account. If you consistently receive inflated tax returns due to increased withholding, they may ask you to change your W-4 or assess a penalty on you. Two, the IRS doesn’t pay interest like your bank does. You’ll make out better if you set aside money every week and place it in an interest-bearing account than you will if you overpay the IRS every week.

Scenario 3 – You Made More Money

Who doesn’t want to make more money? While earning more is arguably a good thing, it can sting a bit at refund time. The tax law breaks income levels into tax brackets or tiers. As your income increases, you will reach a point where you move from one tier to the next, with each tier paying a higher income tax rate. Essentially the more you make, the more you pay.

If you changed jobs, got a raise or earned a promotion in 2020, you may notice your refund shrank a little. You may notice the same effect if you worked an unusually large amount of overtime.

Scenario 4 – A Refund Offset

Your refund could be smaller than you expected if the IRS used it to pay a debt. If you owe any federal government agency money, the IRS can use your refund to pay that debt, and they don’t need your consent to do it. Sometimes state agencies can get a court order to do the same if you’re in arrears on child support payments or owe certain other debts. This is called an offset.

If this happens, you will know. The IRS will send you a letter explaining the tax offset and clarifying how much of your refund they took. If you believe the offset to be an error, you will have an opportunity to dispute it.

Ways to Maximize Your Tax Return

Choose the Right Filing Status

Fortunately, there are ways to reduce your tax liability and increase your refund. One of the simplest is to choose the right filing status. In some instances, it’s best to file married filing separately. This allows you to maximize your refund if one spouse had a lot of medical expenses, for example. The allowable deduction for medical expenses gets calculated as a percentage of income. Filing under one spouse’s income makes the income amount smaller and may allow for a higher deduction.

Filing as married filing separately disallows other tax breaks, however, such as the earned income credit. This can net you a smaller refund. In this case, married filers should file jointly. Researching tax filing statuses takes a little time, but is often well worth the effort.

Embrace Tax Deductions

There’s nothing wrong with keeping your taxes simple and taking the standard deduction, but consider itemizing if doing so will benefit you. Taxpayers can take deductions for all kinds of expenses, including medical bills, taxes paid to their state, student loan interest and charitable donations. Taxpayers can also deduct their self-employment tax. 

Know Your Tax Credits

Even more amazing than tax deductions are tax credits, so be sure you don’t overlook them. Deductions allow you to get credit for amounts you paid for certain expenses. Some credits, however, count as money you paid to the IRS — even if you didn’t. These are called refundable credits.

tax credits

One such credit is the earned income credit. If you owe $250 in taxes and are eligible for an earned income credit of $500, you get the entire credit. Your tax refund in this case would be $250. The first $250 goes towards your tax debt and the remaining $250 gets refunded to you. This can result in you getting back more money than you paid into the IRS!

Deductions and credits are most beneficial when you plan ahead for them. If your refund is lower than you anticipated, however, take some time to peruse the deductions and credits offered. It may not be too late to take a few if you still have the paperwork to back them up.

There are tax credits for many different things, including child care and improving our home’s energy efficiency. Make sure you’re not missing out.

Maximize IRA and HSA Contributions

Another great way to increase your tax refund and help yourself later is through HSA and IRA contributions. In 2020, you may contribute up to $6,000 to your personal IRA account and take a deduction for it. (This number jumps to $7,000 if you’re 50 or older.) Taking this deduction helps you increase your tax refund now and pad your retirement for later, which is a win-win scenario in our book.

The same is true of an HSA. You can contribute for a tax deduction now and then access the money later to cover your healthcare expenses. It doesn’t get any better than helpful tax deductions that let you double-dip.

At Picnic Tax, we want to help you get the biggest tax refund you legally can. Whether you need help choosing a filing status, crafting a plan to maximize your refund or just figuring out why your tax refund is lower than normal, we’re here to help. Find an accountant today and let us take the mystery out of the tax law for you.