The Mistake That Turned My Refund Into a Tax Bill

February 20, 2013

This past weekend I decided to prepare my 2012 tax return.  I typically like to do this early in the year so that I get my tax refund sooner rather than later, but something very strange happened to me this year: I ended up owing the IRS money!  This is unusual for me.  I’m usually getting money back, but call it a case of bad luck or just Murphy’s Law, after writing last week’s blog post on how to estimate the right number of allowances to claim on your W-4 so that you end up close to breaking even with the IRS, I ended up NOT breaking even with the IRS.  WHAT WENT WRONG?

Well, as it turns out, two things occurred last year that caused me to miscalculate my income tax liability: a higher than expected level of taxable incomeand a lower than expected level of deductions.  I don’t think anyone would complain about the first problem, but it is important to recognize that any change in income, for better or for worse, is a reason to adjust your withholding allowances if your goal is to break even with the IRS.  The second reason sounds bad, but this was an unfortunate consequence of a good thing.  Late in 2011, I refinanced my mortgage to a lower interest rate, so as a result the amount of interest I paid in 2012 was a lot less than in 2011.  Since I used my 2011 tax return to estimate my deductions for 2012, I overestimated the amount of interest I would pay, thus overestimating the amount I would claim in itemized deductions.

The moral of the story is to recognize what changes to your financial picture could have an impact on your income taxes.  Here is a brief look at things that might occur during the year that could increase or decrease the amount of income tax you owe:

Changes in income

Sometimes we control this and sometimes we don’t.  It can take the form of a change in pay grade, a larger or smaller bonus, or even an unexpected distribution from a retirement account. In 2012, I received more than I expected in bonus income (don’t tell my boss), which accounted for some of the increase in my income last year.  Another example would be my neighbor who inherited an IRA in which she had to start taking taxable distributions.

There may also be changes in investment income.  Increasing or decreasing your exposure to taxable bonds and dividend-paying stocks could affect your income, as could changes in interest rates. If you own rental property, your income could change based on vacancies.

Jury duty, lottery winnings, forgiven debt, or even last year’s state income tax refund, are all examples of taxable sources of income that could change from year to year.

Changes in exemptions, credits, and deductions

Will you add or lose a dependent this year?  If so, then your exemption amount will change.  In 2013, you will receive a $3,900 exemption for each dependent you claim on your tax return.  Adding a dependent could make your tax bill go down, while losing a dependent might make it go up.  (See IRS publication 501 for more information on exemptions.)

Will your family add a child through birth or adoption or will you have a child turn 17?  Will you pay for dependent care or for a dependent’s education for the first or last time?  If so, you may see changes in the amount of tax credits you are eligible to claim.  A child tax credit is available if you maintain a home for a dependent child under the age of 17, but once they turn 17, you lose the credit.  A child and dependent care credit is available if you use after-tax money to pay for the care of a qualifying child (under age 13) or dependent in order to work or look for work, but you lose this credit if your child turns 13.  Education credits are available if you use after-tax money to pay qualified education expenses for a dependent.

Will you refinance your mortgage, contribute to a new charity, or start working from home?  If so, you may see a change in your itemized deductions.  (I mentioned earlier how refinancing my mortgage not only lowered my interest rate, but it also lowered the amount I reported as a mortgage interest deduction.) For example, if you contributed to Hurricane Sandy relief last year, but don’t necessarily contribute to a similar charity this year, you may not have as much in charitable deductions.  Working from home may allow you to claim a home office deduction, but there are certain criteria you must meet before you plan on benefiting from this deduction.

As you can tell from my story, last year’s tax return is a good place to start, but it is not necessarily where you finish.  As I learned, you should review your withholdings throughout the year and pay close attention to any changes in income, exemptions, credits, or deductions.  Ultimately, it’s those changes that may end up determining whether you owe, or get money back, from the tax man next year.