MAT 245 Module 3 Taxes Example

A $2,600 Refund Is Not a Bonus: Withholding, Marginal Rates and Tax Choices for a Young Professional

Student Name

Business Administration Program, Aspen University

MAT 245: Personal Finance

Instructor Name

Month Day, Year

A $2,600 Refund Is Not a Bonus: Withholding, Marginal Rates and Tax Choices for a Young Professional

Last April, Taylor Monroe received a $2,600 federal tax refund and spent it on a week at the beach, describing it to friends as the best part of tax season. The budget built in Module 2 shows why that is worth a second look: Taylor needed money for a starter emergency fund and to pay down a 24% credit card all year, while $2,600 sat with the Internal Revenue Service earning no interest. This paper explains how Taylor's income is taxed, why the refund happened and what to change. The figures are rounded approximations for teaching, not tax advice, and current-year rules should be checked with official sources. The point is the reasoning, which holds even as brackets and deductions are adjusted each year.

How Taylor's Income Is Taxed

Taylor's income faces four kinds of tax. Social Security and Medicare payroll taxes take 7.65% of wages. The federal income tax applies to taxable income, which is wages minus the traditional 401(k) contribution and the standard deduction. Ohio taxes income at graduated rates, and Columbus, where Taylor works, levies a 2.5% city income tax on earnings.

Marginal and Average Rates

The federal income tax is progressive: income is divided into brackets, and each bracket is taxed at its own rate. Taylor's top dollars are taxed at 22%, but the first dollars are taxed at 10% and 12%. The marginal rate, 22%, is what matters for decisions about the next dollar, such as an extra Saturday shift or an additional retirement contribution. The average rate, total federal income tax divided by wages, is about 9%. Many people believe a raise could push all their income into a higher bracket and leave them worse off; it cannot, because only the dollars above each threshold are taxed at the higher rate.

Why the Refund Happened

Taylor's employer withholds tax from each paycheck based on the withholding form Taylor filled out when hired, and Taylor has never updated it. Jones (2012) studied why so many U.S. taxpayers receive refunds. He found that most taxpayers did not adjust their withholding even after changes in tax law or their circumstances that should have changed it, and that refunds persisted largely through inertia rather than a deliberate wish to save. For many households, overwithholding is a default that no one chose.

Seen and Unseen Taxes

Chetty et al. (2009) ran an experiment in a grocery store, posting prices that included sales tax for some products. Sales of those products fell compared with similar products whose tags showed the pre-tax price, even though shoppers knew sales tax would be added at the register. They also found that consumption of alcohol responded more to taxes included in posted prices than to taxes added at the register. People underweight taxes they do not see at the moment of decision.

Withholding is a tax Taylor never sees, which is one reason the size of the refund was a surprise.

The Cost of Filing

Benzarti (2020) used taxpayers' choices between itemizing deductions and taking the standard deduction to estimate how much effort people will pay to avoid. Many taxpayers gave up deductions worth hundreds of dollars rather than itemize, implying that the time and hassle of tax filing are costly. For Taylor, whose taxes are simple, the lesson is to keep filing simple and organized rather than to chase small deductions.

What Changes When Income Changes

Taylor is considering a Saturday shift at a second practice, worth about $9,000 a year. At the margin, that income would face the 22% federal rate, 7.65% in payroll taxes, Ohio's rate and the city tax, so Taylor would keep a little under two-thirds of it. The second employer would withhold based on its own form, which often leads to underwithholding when someone holds two jobs, because each employer withholds as if its wages were the person's only income. Taylor would need to account for both jobs on the withholding form or make estimated payments to avoid owing money and a penalty in April.

Tax-Advantaged Accounts Beyond the 401(k)

Taylor's employer offers a high-deductible health plan with a health savings account. Contributions to an HSA reduce taxable income, grow without tax and can be withdrawn tax-free for medical costs, which makes it one of the few accounts with tax benefits at every stage. The budget's $50 a month for health savings goes there. If Taylor later wants to save more for retirement than the 401(k) match requires, an individual retirement account is another option, with income limits that should be checked each year.

Recommendations

First, Taylor will update the withholding form so that withholding roughly matches the expected tax, using the IRS withholding estimator, which should reduce the refund to a few hundred dollars and add about $200 a month to take-home pay. That $200 goes to the credit card until it is paid off, then to the emergency fund. Taylor will check withholding again each January and after any raise. Second, Taylor will keep the 401(k) contributions traditional, pre-tax, for now: at a 22% marginal rate, each $100 contributed lowers federal tax by $22. A Roth option, taxed now but tax-free later, will make sense in years when Taylor's rate is lower or when income is expected to rise substantially. Third, Taylor will keep a folder for pay stubs, the W-2, 401(k) statements and student loan interest statements, since student loan interest may be deductible.

Conclusion

Taylor's refund was an interest-free loan to the government made by default. Jones explains the inertia behind it, Chetty, Looney and Kroft explain why unseen taxes surprise people and Benzarti explains why keeping filing simple has value.

References

Benzarti, Y. (2020). How taxing is tax filing? Using revealed preferences to estimate compliance costs. American Economic Journal: Economic Policy, 12(4), 38-57. https://doi.org/10.1257/pol.20180664

Chetty, R., Looney, A., & Kroft, K. (2009). Salience and taxation: Theory and evidence. American Economic Review, 99(4), 1145-1177. https://doi.org/10.1257/aer.99.4.1145

Jones, D. (2012). Inertia and overwithholding: Explaining the prevalence of income tax refunds. American Economic Journal: Economic Policy, 4(1), 158-185. https://doi.org/10.1257/pol.4.1.158