Many taxpayers in the U.S. have come to expect a nice treat every year in the form of a tax refund. To some people who don’t prepare their own tax returns, it’s a mystery how the refund is calculated.
The idea is really quite simple. After calculating your taxable income, you use the information in the tax tables to determine your total income tax for the year. This amount is then compared to the amount that you actually paid throughout the year (in the form of withholdings from your paychecks). If the amount you paid is more than your tax, you are entitled to a refund for the difference. On the other hand, if the amount you paid is less than your tax, it’s time to get out the checkbook.
Withholding: Why It’s Done
If you work as an employee, you’re certainly aware that a large portion of your wages/salary doesn’t actually show up in your paycheck every two weeks. Instead, it gets “withheld.”
The reason for this is that the Federal government wants to be absolutely sure that they get their money. They know that many people have a tendency to spend literally all of the income they receive (if not more). As a result, they set up the system so that they’d get their share before taxpayers would have a chance to spend it.
The amount of your pay that gets withheld is based upon an estimate of how much tax you’ll be responsible for paying over the course of the year. Your employer’s calculations for withholding are based upon what they expect your income to be, and how many exemptions you will be claiming. (This is why people are required to fill out a Form W-4 indicating how many dependent children they have when they start a new job.)
Withholding: How It’s Calculated
At this point you may be thinking, “OK. Well I just learned that I’m in the __% tax bracket, and it’s obvious that my employer is withholding way more than that!”
You’re probably right. That’s because your employer isn’t just withholding for Federal income taxes. They’re also withholding for social security taxes, Medicare taxes, and (likely) state income taxes.
Social security taxes are calculated as 6.2% of your earnings, and Medicare taxes are calculated as 1.45% of your earnings. Before you’ve even begun to pay your income taxes, 7.65% of your income has been withheld.
Great. So…How Much Is My Refund?
Your refund is calculated by comparing your total income tax to the amount that was withheld for Federal income tax. Assuming that the amount withheld for Federal income tax was greater than your income tax for the year, the difference is the refund that you’ll receive.
EXAMPLE: Nick’s total taxable income (after subtracting deductions and exemptions) is $35,000. He is single. Using the table for single taxpayers, we can determine that his Federal income tax is $4,931.25.
Over the course of the year, Nick’s employer withheld a total of $9,000 from his pay, but only $6,000 of that was to go toward Federal income tax. His refund will be $1,068.75. ($6,000 — $4,931.25)
- Every year, your refund is calculated as the amount withheld for Federal income tax, minus your total Federal income tax for the year (calculated using this year’s tax brackets).
- A large portion of the money being withheld from each of your paychecks does not actually go toward Federal income tax. Instead, it goes to pay social security and Medicare taxes (and possibly state income taxes).