Your Paying Too Much!

I just read the average U.S. federal income tax refund is up about 5% from the previous year, at almost $3,200. Sounds great, right?

Think again.

That $3,200 is NOT free money. It is NOT a mad money account. It is an interest-FREE loan YOU GAVE to the U.S. Government.

Think of what you could have done with that money if you hadn't loaned it interest-FREE.

Paid down and existing debt? Had more money for groceries? Had more money for your kids? Taken a trip? Started a college fund? Invested the money and earned a return? Gave more to support your faith and other charitable causes?

Your goal should be to pay what you owe in taxes. No more, no less. Obviously, it's not always easy to hit that exact mark -- so owing a few hundred or getting a refund for a few hundred is the next best thing.

Overpaying your taxes by several thousand dollars on a regular basis is NOT a cause for celebration. It should be a wake up call that you need to do a better job predicting what you should pay during the year to satisfy your income tax obligation for that year. There are exceptions to every rule (for instance, a natural disaster), but that should be your goal.

So how do you DO that? The easiest way to get a ballpark estimate to get you started is to look at your effective tax rate for the previous year.

Take the amount you paid in taxes during that year and add what you owed (or deduct the refund you received) on that annual income tax return. Divide the result by the Adjusted Gross Income (AGI) shown on that return. This will give you a good starting point.

This percentage won't be exact; your life isn't constant so your taxes won't be either. And then there is the issue of Modified Adjusted Gross Income (MAGI) -- but that's for another time.

Multiply your gross income by this new tax rate. You don't have to try to include ALL of your gross income -- just the major contributors. Each taxpayer's situation will be different.

However, making sure you pay income taxes during the current year at a rate roughly equivalent to your prior year effective tax rate should get you reasonably close to your goal. Each year after your federal income tax return is accepted by the IRS, compare the new effective tax rate to what you are currently paying and adjust year-to-date as necessary. But be sure to take into account any one-time issues that should be included or excluded from your calculations (like that natural disaster).

When I say "adjust year-to-date," I mean that you should adjust your effective rate for the new year to account for the months already paid at the old rate. So take your new rate, multiply it by your current year annual gross earnings so far, and compare it to the current year taxes already paid. If you find you haven't paid enough, you can increase your effective rate slightly to make sure you have met your goal by the end of the year.

Do this, and maybe you'll have a bit more left over at the end of your paycheck than you did last year.