Tax Refund vs. Tax Liability: What’s the Difference?

Tax season is always a busy time, and one that many look forward to.

Not only do most individuals look forward to a nice chunk of money back, so do the businesses that rely on people spending that money.

This tax season has been filled with far more drama than most years, and with the first major changes to the tax law in 30 years it’s no wonder why.

However, it isn’t necessarily the changes in the tax law at the root of the angst, although it is a contributor, it’s the changes in tax refunds that have people in an uproar.

Early data from the IRS indicated that refunds have dropped around 8.4%, with the average refund dropping several hundred dollars. Furthermore, many of those that normally receive a refund actually find themselves owing money this year.

Many are understandably upset and ready to write off the new tax law as a failure.

While lower refunds and owing money has been the emphasis, the real takeaway from this tax season is more fundamental and exposes a problem that has always been there.

The outrage over lower refunds serves to show just how confusing taxes are for most people.

“The changes were supposed to lower our taxes, but this year my refund is smaller.”

How many times have we heard this over the last couple of months?

Although taxes can be complicated and there are several factors that have gone into the changes in refunds we’ve seen this year, it’s clear from comments like the one above that many do not understand the difference between their tax refund vs. tax liability.

Which is why we’re here.

Read on to gain a better understanding of your tax refund vs. your tax liability, and why your tax return may not be as high as you’d hoped this year.

Disclaimer: The information we’re about to provide does not include the impact of income earned through self-employment or business taxes.

Tax Basics

Before we get into tax refunds vs. tax liability we need to give you a basic overview of the tax system.

The taxes you owe (your tax liability) are based on several things, most notably your taxable income (there are some states without an income tax but you’ll still pay federal income taxes) and your filing status (more on these later).

Next, your taxable income and filing status will determine which tax bracket you fall into, which will then give you your tax rate.

No matter the tax bracket you fall into (and thus your tax rate), it’s important to remember that not all your income will be charged at that rate. Our tax system is graduated, meaning you’ll pay various tax rates only on the income that falls within that bracket.

For example, if you’re single you’ll pay 10% in taxes on the first $9,525 you make, then 12% on the next amount up to $38,700, and so on.

To learn more about tax rates, brackets, and our graduated tax system, check out our article about the 2018 Tax Changes You Need to Know.

Tax Refund vs. Tax Liability

Tax Refund

Let’s start with tax refunds because they are easier to understand.

Most people are very happy when they receive their tax refund, and many treat it like a free chunk of money from the government.

The truth is, when you receive a refund you are simply getting back your own money that has been loaned to the government interest-free.

You see, every pay-period your employer withholds a certain amount of your check for taxes.

Do you remember filling out a form called a W-4?

This form is filled by you so your employer can withhold your estimated share of taxes from your paychecks. The refund you are getting is the balance from your employer withholdings minus the taxes you owed for the year.

How many allowances should you claim? Here’s a simplified explanation:

  • The more allowances you claim in the W-4 form, the less tax will be withheld from each paycheck, resulting in higher take home pay but also increasing the likelihood of owing taxes.
  • The fewer allowances claimed in this form the more taxes will be withheld from each paycheck, resulting in lower take home pay but also increasing the likelihood of a refund.
  • Claiming “0” allowances will result in your employer withholding the maximum amount possible for your situation.

For more information about allowances and withholding you can read this article from SmartAsset.

Thus, tax refunds are the difference between withholding’s from your paychecks and your tax liability amount.

If more is withheld than your tax liability you get a refund. If less than your tax liability is withheld you owe money.

As a result, the amount of money withheld from each pay check has a direct impact on your tax refund at the end of the year, and will determine whether you get a bigger refund, a smaller refund, or if you owe taxes.

The key is that regardless of whether you owe money or get a refund at the end of the year, your tax liability is the same.

Now let’s shed some light on what tax liability is.

Tax Liability

Your tax liability is simply the amount you owe in taxes every year, and is determined by four things: your filing status, your taxable income, your tax bracket, and tax credits.

Filing Status

Let’s tackle filing status first because it’s the most simple.

Filing status is simply based on your household and how you identify, and include 5 options:

  • Single
  • Married filing jointly
  • Married filing separately
  • Head of household
  • Qualifying widow(er) with dependent child

You will be taxed more or less for each income range depending on your filing status.

Taxable Income

Next, let’s tackle your taxable income.

Taxable income is your gross income (total money made) minus your deductions.

There are two ways you can handle deductions: standard deduction and itemized deduction.

The standard deduction is a set amount. For example, the standard deduction for those who are filing as single for 2018 is $12,000, meaning those who choose that deduction will see their taxable income lowered by $12,000.

On the other hand, itemized deductions consist of many different items such as mortgage interest, medical expenses, charitable contributions, etc.

It’s important to note that you’ll only benefit from doing an itemized deduction if that amount exceeds the standard deduction for your filing status.

Tax Bracket

Once you know your taxable income and your filing status you can determine your tax bracket.

Remember, our tax system is graduated so the percent you’ll pay only applies to income above each bracket threshold.

Using our example from before, if you’re single you’ll pay 10% in taxes on the first $9,525 you make, then 12% on the next amount up to $38,700, and so on.

The higher your taxable income, the higher your tax rate the more your tax liability will be.

Tax Credits

The last thing that determines your tax liability are tax credits.

Tax credits are the best when it comes to saving tax dollars, and where most find their biggest tax advantage.

While tax deduction reduce your taxable income, and thus the overall percent of income taxed, tax credits offset your tax liability dollar for dollar.

For example, if you are single and in the 10% tax bracket, your standard deduction of $12,000 will only reduce your tax by $1,200 ($12,000 X 10%). If you owed $4,000 in taxes, the $12,000 deduction will reduce your taxes by $1,200 and your net tax liability would be $2,800.

On the other hand, if you owe $4,000 in taxes and you have $2,000 in tax credits, your tax liability is reduced by the entire $2,000, not just 10% of the $2,000. Your net tax liability is now $2,000, which is $800 less than the deduction.

In this example you see that a $12,000 deduction only saved $1,200 in taxes while the $2,000 in credits reduced the taxes by the full $2,000!

Now, just to be clear, there are two kinds for tax credits: nonrefundable tax credits and refundable tax credit.

Both will reduce your tax liability dollar for dollar. However, there is slight difference between these two tax credits.

  1. Nonrefundable tax credit are limited to the amount you owe in taxes. For example, if you owe $2,000 in federal taxes and you have non-refundable credit of $3,000, the maximum credit you are entitled to would only be $2,000. The remaining $1,000 is forfeited.
  2. If you have a refundable tax credit that exceeds your tax liability, the IRS will refund you the balance. In other words you are entitled to the entire credit amount regardless of how much you owe in taxes. For example, if you owe no taxes to the IRS and have a refundable credit of $2,000, you will get the $2,000 in a refund.

There are several nonrefundable and refundable tax credits. Here are some examples:

  • Earned Income Credit – This is a refundable credit. You have to be within a certain income range and family status to qualify for this credit.
  • Child tax Credit – This is a nonrefundable credit of $2,000 for each child claimed as a dependent.
  • American Opportunity Credit (AOC) – You can receive up to $2,500 for undergraduate college costs. For this particular credit, only 40% is refundable. The other 60% is nonrefundable. Based on your situation you may get all 100% refunded.

Do You Owe More of Less?

As mentioned in the introduction, the inspiration for this article came from people’s unhappiness about changes in their tax refunds brought about by the changes in the tax laws, and as a result, changes in employer withholding.

However, if you’re basing your views of the new tax laws on your tax return you’re barking up the wrong tree.

As you can see from our explanation, your tax refund (or not) is simply the difference between your tax liability and the amount withheld by your employer.

What really matters, and what you should look to compare, is your tax liability because that is the amount you actually owe to the government.

Thus, if you really want to know the impact of the new tax law you need to compare your tax liability for this year with that of last year. If you’re tax liability (the amount you owe) is less, then your taxes have lowered. On the other hand, if your tax liability is more, then you are paying more in taxes compared to last year.

How Come My Refund Is Smaller, or Worse, I Owe?!

The answer for why your refund is smaller, or why you may owe taxes, this year is partially based on your individual situation and how changes in the tax brackets, tax percentages, and deductions have affected you.

However, the main culprit for changes in refunds appears to be errors in tax withholding.

In order to reflect the changes in the tax law, the IRS released new withholding tables for employers to use in determining how much to take out of each paycheck.

While most saw larger paychecks, the unintended effect was that employees prepaid less taxes over the course of the year, and in some cases, didn’t pay enough.

Thus, even though many saw their tax liability decrease (the amount they owe in taxes was less), their employers didn’t withhold enough of their taxes throughout the year, resulting in smaller refunds or owing money.

Although changes to tax refunds was an unpleasant surprise for most, the real determinant of how the new tax law impacted you is in your tax liability, not the refund.

If your tax liability was reduced, yet your refund was less or you owed, it means you were paid more of your money throughout the year instead of in a lump sum refund.

Moral of the Story

Changes in the tax laws have created quite an uproar this tax season, with many unexpectedly receiving much smaller refunds or even owing money.

However, the biggest takeaway from this tax season is not the lower refunds, but the lack of knowledge of our tax system by the average American.

It’s important to understand the difference between tax refunds and tax liability, and the factors that make up each.

Tax refunds are the difference between your tax liability and the amount withheld by your employer, while tax liability is the amount you owe to the government.

If you do receive a refund, remember that it’s not free money from the IRS, but rather the excess amount they took from your paycheck in taxes throughout the year.

Thus, a true understanding of how the new tax law affects you is reflected in a comparison of your tax liability from this year to last, not the size of the refund you receive or whether you owe money.

Furthermore, changes in refund are largely due to changes in the withholding tables used by your employer, which resulted in many people prepaying less taxes and receiving more take-home pay for each check.

Like it or not, a lower refund does not necessarily mean your taxes increased.

Now that you know, take a look at the withholding allowances on your W-4 and make adjustments as necessary to avoid any unpleasant surprises for next tax season.



Tawnya is a 34-year-old Special Education teacher in the sixth year of her career. Along with her partner, Sebastian, she runs the blog Money Saved is Money Earned. Tawnya has worked extremely hard to reach her goals and remain debt-free.

She holds an Honors BS in Psychology from Oregon State University and an MS in Special Education from Portland State University and has had a pretty successful writing career, first as a writing tutor at the Oregon State University Writing Center, and in recent years, as a freelance writer.

Tawnya and Sebastian have a wealth of knowledge and information about personal finance, retirement, student loans, credit cards, and many other financial topics. It is this wealth of tips and tricks that they wish to pass on to others.