People are so full of good advice – Especially when it comes to your taxes.
Do you want a new car? “The sales tax on your new car is deductible.”
Feeling philanthropic? “Your donation is tax deductible.”
Need new doors or windows? “You can get a nice energy credit.”
Feeling bad about all those loosing lottery ticket? “My neighbor deducted all of his losing tickets.”
Student loans? “Big deal. The interest is tax deductible”
And so it goes with medical bills, mileage, home mortgages…so many things can reduce your taxes! You should spend! spend! spend!
It all sounds great. Until you do your taxes, and you find that not much has changed. So what happened to that awesome refund you were promised.
Lots of things.
Let’s look at the actual reason for doing your taxes every year. Our United States tax is a “pay-as-you-go” system. We are expected to pay our taxes on income as we earn it. This is why our employer withholds taxes every pay day. Individuals who are self-employed are expected to make estimated payments every quarter as well. Then, by April of the following year, we look at all our income and determine how much we should have actually paid. Did we pay too much? – We get a refund. Did we pay too little? – We owe taxes.
Now, to complicate matters, the United States government offers incentives to encourage their citizens to act “responsibly.” The government also reduces taxes to provide much needed relief in specific circumstances.
But let’s go back to that stack of deductions.
If you haven’t paid any taxes to the IRS, you won’t get a refund. By the very definition of the word, refund, you are getting back what you have already paid in. So, if you haven’t paid in any taxes you won’t get any money back. Refund is money that you already paid in.
My sister-in-law plans to retire next year. Due to the nuances of the tax system, she will not owe any taxes next year. She will not be required to file. She will she not get a refund. In fact, she won’t have paid any taxes at all. “But what about all my medical bills? Can’t I deduct them?,” she asked me. The answer is yes and no. Yes, you can keep track of all your deductions, fill out a tax form and send it off to the IRS. But, no, you won’t get any refund since you never paid any taxes in the first place. In fact, your income is below the filing threshold so the IRS doesn’t even require that you fill out a tax return. So what is the point of filing?
(Just to be clear, there are a few certain times that you can get money back that you hadn’t actually paid in, generally when there are children involved. These are credits. Some of them are refundable. We will discuss that in another post. -MoneyMommy)
Perhaps you did have a job and you did pay taxes. Good for you! Currently, nearly every American citizen can reduce their gross income by over $10,000.00 to get to their taxable income. If your taxable income is decreased to zero or below, you should not owe any taxes. In fact you should get a full refund of your federal taxes that were withheld throughout the year. More deductions will not cause you to get a bigger refund when you are already getting everything back.
The standard deduction is a gift to the American populace. Nearly every taxpayer can take the standard deduction, currently $6,200 for a single person, off their taxable income. If all your deductions do not exceed the standard deduction, it is pointless to itemize your deductions. For instance, my neighbor has paid off his home. His property taxes are just $525 and he donates $300 to his favorite charities, for total deductions of $825. He can reduce his taxable income by $825 or he can use the delightful standard deduction and reduce his taxable income by $6,200. It’s a no-brainer. He’ll reduce his income by the full $6,200, and save at least $620 on his taxes, if he’s in the ten percent tax bracket. AND he did not have to spend any of the $6,200 in the first place. Married couples can take double that amount ($12,400!) off their taxable income. So, if your deductions are not even close to the standard deduction, all those papers that state “may be tax deductible” will not affect your refund at all.
But, beware! higher earners may run afoul of the dreaded AMT tax. The AMT is a parallel tax system established in 1969. The AMT tax is designed to ensure that everyone pays their fair share of taxes by eliminating many deductions. I’ll save that topic for another day.
To recap, deductions can certainly increase your refund by reducing your taxable income. But it is certainly not a one-size-fits-all. You need to examine your own circumstances to see what course of action is best for you. When in doubt, talk to a tax professional. And don’t rely on hearsay from your neighbor down the street. Chances are, he’s about to be audited for deducting all those losing lottery tickets.