[Editor's Note: This guest post was submitted by longtime WCI reader, physician spouse, and personal finance freelance writer, Ryan Trettevik. We have no financial relationship. It discusses tax refunds, why you shouldn't want one, and what can be done to reduce them. The secret to all this is # 1 to make sure you don't pay any penalties by staying in the safe harbor and # 2 make sure you have enough money to pay all of your taxes at the end of the year.]
I never thought embarrassment was an emotion I’d feel when entering our info into TurboTax, but that’s exactly what happened this year. My husband transitioned from a resident to a fellow in 2018. He was doing a non-ACGME fellowship that included half time attending work so his income significantly increased. As I entered the numbers into TurboTax our federal return cranked higher and higher, eventually landing on a big tax refund of $9,000.
How did this happen? Well, despite the fact that we’re married and have two kids, my husband’s W-4 was set to single with zero allowances. In prior years this had worked fine. The extra withholdings made up for most of the taxes owed on my 1099 income and we had a tax bill of a couple hundred dollars each April. However, when his income increased in 2018 (and we added our second child) the settings on his W-4 meant the small extra withholdings we were used to had changed to much larger extra withholdings.
What’s Wrong With a Big Tax Refund?
What’s wrong with a $9,000 tax refund? That’s gotta be better than these folks that were hit with a $8,000 tax bill, right? Wrong. We had loaned the government $9,000 dollars interest-free. I don’t know about you, but we don’t go around giving out interest-free loans. Or at least we didn’t know we did.
(Sidenote: I’m comparing a big refund and big bill with the assumption that you have the cash to pay your tax bill. Getting hit with a large tax bill and not having the money to pay it is certainly worse than a large refund.)
Not only had we given the government a silly loan, but I hadn’t opened the solo 401k I was eligible for with my 1099 income because we didn’t have money to contribute to it. If we hadn’t loaned the government that money, we could have filled more tax-advantaged space!
I was embarrassed. There I was, avidly reading all the personal finance blogs and books I could get my hands on, taking the coursework for a CFP certification, and I hadn’t checked our tax withholding in a year where there were major changes to the tax laws, our income significantly changed, and we had another kid. (Wait, maybe that’s my excuse, we had an infant and a 2-year-old!) I figured our tax withholding would be off and even mentioned that to my husband, but I hadn't realized how far off it would be and I didn't take the time to calculate it.
When Should You Adjust Your Tax Withholdings?
This is particularly important when you transition to an attending because if you are withholding too much, the money can go further in that first year with an increased income. For example, in future years, $9,000 won’t make a difference as to whether or not we can fill all of the tax-advantaged space available to us. When you only have six months of an increased income in the year you graduate from residency, overpaying your taxes creates a more significant reduction in the amount you have to put towards other important goals like paying off student loans or saving for retirement.
Plus, as I mentioned earlier, my husband was getting paid half-time in his fellowship. If he had gone straight into a full-time attending position, we would have been giving the government a five-figure loan.
After making this blunder, I did a bit of reading on when you should adjust your W-4. There are certain life changes that should remind you to check your withholding and adjust your W-4 as needed. These include:
#1 Large Changes in Income
There aren’t many fields where someone’s income doubles, triples, or quadruples from one year to the next. Physicians are somewhat unique in this experience, making those transition years an important time to check your withholdings. Other times you’ll see a big change in income could be when you start or stop a second job.
Ryan Trettevik and husband Brad Harris
Things like significantly increasing your pre-tax retirement contributions, large amounts of student loan interest deductions, or alimony expenses can also adjust your income, and therefore should lead to changes in your withholdings.
If you’re married, a large change in the difference between your income and your spouse's income (even if the total household income hasn’t changed significantly) could mean you need to adjust your withholdings. W-4’s aren’t coordinated for married people, or for single people with multiple jobs, so it’s important that you use a withholdings calculator to set both of your exemptions accurately.
#2 Big Life Changes
Have a kid? Is your kid no longer a dependent? Did you get married? Divorced? Buy a home? All of these will change your tax situation. It turns out you’re required to adjust your W-4 within ten days of an event that lowers your exemptions, such as divorce.
#3 Eligible for New Deductions/Credits
Large medical expenses, big gifts to charity, dependent care expenses, education credits, etc. could affect your taxes enough to change your withholdings.
#4 Having Taxable Income Not Subject to Withholding
This type of income would include a side hustle taking off and increasing your self-employment income, capital gains, or IRA distributions.
#5 Major Changes to Tax Law
This is a good time to double check your withholdings since it might not be clear how tax law changes will affect your specific situation.
These are the most common reasons people need to adjust their W-4. While our situation may have been somewhat unique since we were accounting for the taxes on my 1099 income by withholding more on my husband’s W-4, there are plenty of you that are going to fall under one of those categories. Four of those categories actually applied to us in the last tax year and we still didn’t check our withholdings. Oops!
Considerations for Married Couples
As you can see, things can be more complex for married couples than for single filers. Changes for one spouse affect the couple’s overall tax picture and are unaccounted for on the other spouse’s W-4. If you file married filing jointly, you’ll want to use your combined income when figuring out allowances. You can then claim all of the allowances on one spouse’s W-4 or divide the allowances between them.
Check Withholdings Early in the Year
It’s best to check your withholding early in the year to make sure can get your withholding as accurate as possible from the beginning, but it’s better to check anytime in the year than never. You can change your payroll exemptions as often as you like. You don’t need to get it perfect the first time if your life situations change again later in the year, you can adjust things accordingly.
Tax Withholding Calculators
Not sure where to start? Enter your info here. Is the calculator perfect? No. But we learned it’s a lot better than not attempting to figure out your proper tax withholding. Once you get your results, you can adjust your W-4 appropriately. We adjusted this immediately for this year once I saw our mistake and will check on it again later this year when we have a better idea of my husband’s income to be sure additional tweaks aren’t necessary.
This took a total of 5-10 minutes. Going through these steps will ensure you aren’t giving the government a loan when you could be putting that money to work for you. It will also ensure that you aren’t surprised by a large tax bill that you aren’t prepared to pay or a penalty for underpaying.
Putting Our Refund to Use
We’ve made the best of this small blunder and used the refund to fill retirement accounts for this year sooner than we planned. It’s nice to get a jump start on filling those accounts as it will let us move on to the next buckets we’re trying to fill sooner, but the perfectionist in me would have preferred to fill more tax-advantaged space last year. Ideally, you’re all smarter than me and won’t run into this issue. If that’s not the case, I hope that sharing this experience will help someone else avoid this first world problem!
How do you determine the number of withholdings to claim each year? Are you changing your withholdings going into 2019 tax year? How has the new tax law affected the amount you withhold? Comment below!
Thank you! When you have screwed this up, as I have in the past at times and ended up owing them a lot more than allowed, you can often avoid a penalty by annualizing your income (we do that a lot now when end of year distributions are bigger than all our other dividends), and even perhaps when you have forgotten to do it when you are required to, claiming ignorance of the rule in a letter. (Yes, it took me longer than just adjusting the W4 would have.)
I was just thinking as I read that we are set- my 0 withholding still left huge estimated tax payments on our Roth conversions- but like you I just went from half year to full year Dr pay and won’t do any Roth conversions at this bracket anyway. Thanks for the timely reminder!
I’ve done multiple posts about why getting a refund is a lost opportunity cost but many in the online finance space still defend it. As you point out it takes money away that you could have used to max out 401ks or IRAs the previous year, and it gets eroded by inflation.
It’s as if you bought a CD that pays 0%, agreeing to get the money back next March or April. It makes no sense but many are happy to do it intentionally. Sometimes life circumstances change and it hits you by surprise, which is understandable. But it’s easy to adjust W4’s to correct for.
I keep pushing my new “tax refund service”. Send me $1,000 every month of the year and I’ll send you $12,000 next April. For some reason people won’t sign up for it, but that’s basically what they’re getting from the IRS.
Very tweet worthy reply/comment, Dr. D: )
I used to be happy when I was getting back a large tax refund each year when I first became an attending. And then that attitude changed when I realized that it really meant that I overpaid and I am just getting back that money without interest (ie the interest free loan to the government you pointed out).
I now play the game the other way and manipulate the rules so that the government has instead loaned me money interest free (you have to be cautious about doing this because you don’t want to trigger IRS underpayment penalties). But the best way to do it is making sure what you owe is less than 10% of the total tax incurred that year (another one is to qualify under the safe Harbour rule and have put in 110% of your previous years tax) . Because of my salary and my side income streams, my tax bills for the past 3 years or so have been in the $270-320k range. Which means I can get an interest free loan of $27-30k that year without paying penalty (I typically have been setting my W2 deductions to 0 and have no additional W-4 withholdings. This year I owed $7k at tax time so I have plenty of wiggle room left). Once my income streams get close to the trigger points, then I will start W4 withholdings.
More info on safe harbor rules here:
https://www.whitecoatinvestor.com/estimated-taxes-and-the-safe-harbor-rule/
2018 tax liability was a true estimate when selecting tax withholding from all my sources of income. Personal exemptions were lost but child tax credits were increased. With less tax withholding guidance, I had to pay but the bill was small.
Being W2 and a tracker of my deductions, I usually use TurboTax software during the year at the halfway and 3/4th marks to estimate my tax return for a zero end-of-the-year tax liability by estimating annual income from my paystubs . Of course this is using the previous year tax tables and limits but this only ensures a small error in my favor. This analysis gives me time to adjust withholdings for the remainder of the year and use my money earlier in the year than a large tax return would allow.
I’ve gotten in trouble on various personal finance forums for this opinion, but I’ll say it anyway. For many couples, particularly those with high and variable income, a tax refund is not the end of the world. It sure beats accidentally under-withholding and paying penalties, or dealing with estimated tax payments if you don’t have an accountant.
Of course with enough effort one can micro-manage their tax payments and estimated payments to avoid a big refund, but to what end? Is a $10K refund on a $200K tax bill really that big of a deal? [spoiler]It’s not[/spoiler]. I’m not saying you shouldn’t make a best-effort to withhold approximately the right amount. But the 80/20 rule applies. 20% of the effort gets you 80% of the result, and that last 20% takes 80% of the effort. Not worth it, unless you think it’s a fun hobby.
I wouldn’t focus so much on getting things right. I would focus on two things:
# 1 Avoiding penalties
# 2 Making sure you have the money set aside to pay taxes. If I don’t owe penalties, I’m more than happy to write hundreds of thousands in tax checks on April 15th like I did this year. I just need to make sure I have the money to do so!
Ha, I was typing up my response and didn’t see yours! I agree.
Thank you for the post. I think it is a great idea to re-evaluate things with the big events that you describe. However, I’m going to play devil’s advocate. The interest-free loan was actually spread out over a year (plus however many months til your refund credited), but let’s say 7% or $630 opportunity cost to make it easy. (Yes, I’m ignoring your lost pre-tax issue.) Yeah, that is real money, but I do not think it is worth beating yourself up. My taxes have a lot of moving parts, with big income swings end of December as the practice zeroes out the books, and then there is the parade of K-1s that don’t come til Mar/Apr. To be honest, if I’m within 10% of calculated tax liability vs withholding, I feel like I nailed it. This year I was inside 1% and I felt like I hit a hole-in-one (particularly given a lot of movement in my taxable accounts and the TCJA).
For people at the higher end of their income, this issue is much like skipping lattes or pursuing travel rewards. Yes, it actually will make a difference of several hundred dollars for you each year. But if it’s not fun, it’s not worth doing. Spend your time doing some other thing that you enjoy.
We’re one of those people who gave a 5-figure loan to the government last year. Between the tax law changes, and my going part time in Sept, we didn’t have great confidence in estimating our taxes, so just let our current withholdings ride for 2018.
DH is the physician, and has a W2 position and a K2 moonlighting position. Both have variable income due to the bonuses. Mine is a W2 position, and since I’ll be part time for all of 2019, our income will to put us in the 24% bracket from 32%. So going the 110 % safe harbor route for this year would likely leave us with a large tax refund next year also.
The one change for this year is that DH does not need to make estimated quarterly tax payments for the K2 position, because his W2 withholdings more than cover it. Maybe I’ll bug DH to give me his paystubs in the fall to run estimates though TurboTax, because I think we could still end up with a $5-10k refund next year with our current set up.
Oops – K1. Partnership, not mountain
This is a great reminder to adjust with-holdings in response to the new tax law.
I neglected to do this, and after shifting around some assets last year to get a larger emergency fund, I ended up underpaying my taxes by about $38,000!
That was a painful check to pay out to the IRS in April.
Before I get congratulations for underpaying the government all of 2018, I should point out that an unintended consequence of this was that my income and savings projections for the year were a bit skewed. Essentially, I though the Dr-ess and I were making about $2000 a month more than we actually were in 2018.
Luckily most of the extra was put into the market, and despite the dip in December, 2018 was pretty rewarding to investors.
Now that I’ve righted the ship, I’ll have to do a budget deep dive and see where we are at. Hopefully it won’t be too far off from the mark!
— TDD
The safe harbor is a trap. If you pay 110% of last year’s liability and your current year liability is the same then you have a refund of 10% of your taxes.
For good times, with the market going up and little or no deductible losses investment returns may go up enough to make your liability go up 10%. With market drops one can be making big loans to the feds.
Which means the only alternative is to track realized gains through the year watch for late in the year planned distributions from funds and adjust withholding to get it right.
It is better to do this with withholding than estimated tax payments since the former is always considered timely paid. Some years I have had my entire last few paychecks withheld.
Not sure I’d call that a trap, but I agree if your income doesn’t climb you’re better off just paying what you paid last year instead of going for the safe harbor. That said, the safe harbor has saved me from penalties in most of the last ten years (I can’t remember the last time I got a refund).
I agree the withholding at year end can be an ingenious strategy.
I tried the IRS withholding calculator, and despite my 10k refund for 2018 and another dependent, it says I will owe 12k at the end of this year. I suspect it’s because of my maternity leave, where I didn’t get paid (and thus, didn’t have tax withheld, so my year to date tax paid is less than expected for my total anticipated income). I was planning to decrease my withholding based on last year, but now I’m hesitant to do so. Is there a better way to calculate tax when income is not even throughout the year?
you should just get used to estimating your own taxes – if you like spreadsheets then excel1040.com is an excellent tool to help. Or you can use Turbotax etc.
Tax software. If you do your own taxes, use Turbotax or similar. If you pay someone, have them estimate it for you.
Hi there,
I am married filing jointly. My wife does not work and I have income of $550k. Up until now, my biweekly federal withholding has been listed as single and my state is married. I changed federal to married. I am curious to know if now that I changed it, I will be withholding less each paycheck and get slammed with a big tax bill at the end? I believe in 2020, I owed 15K and will get back 13k (NY) with me being “single” on federal and “married” on state.
Thanks!
Yes and maybe. You’ll almost surely have at least a smaller refund, but you’ll also take home more as you go along.