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The tax refund you've forgotten

Rushing to file a tax return probably isn't most people's idea of fun, but this year may be the time to get going early.
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Rushing to file a tax return probably isn't most people's idea of fun, but this year may be the time to get going early.

The reason? You may be getting a larger-than-average tax refund this year. Maybe a lot larger.

You remember, of course, that Congress passed, and President Bush signed, major tax-cut legislation last year. But you may not recall that the Bush administration opted not to fully adjust withholding tables -- used by employers to determine how much income to set aside for taxes -- following those midyear reductions, leaving millions of taxpayers over-withheld for the year.

The withholding gimmick could be called cynically political, but let's not be harsh. It'll feel real good this spring.

In fact, according to the Treasury Department, the combination of tax refunds and taxes that won't have to be paid because of last year's cuts will lop almost $100 billion off the amount of cash coming in to the government in the first six months of this year -- $39.3 billion in the first quarter and $60.5 billion in the second.

The over-withholding occurred because the tax cuts, though enacted in May, were retroactive to the beginning of the year. The withholding tables used by employers until that point, of course, were based on the higher tax rates. When it issued new tables, the Treasury Department could have adjusted them to take the earlier, higher withholding into account so that taxpayers could get more money sooner, and would come out about where they usually do in terms of a refund.

But that would have made the withholding too low to be used for a full 12 months, thus requiring yet another adjustment at the beginning of this year, one that might have looked to a lot of people like a tax increase. So when the new tables lowered withholding, beginning last July, they matched the new, lower tax rates at that point but ignored the previous higher withholding. When workers file their 2003 returns they'll get back last spring's over-withholding as a lump, which they may choose to spend and perhaps boost the economy in an election year.

People who didn't want to be giving the government an interest-free loan last year could have filled out new W-4 forms and decreased their withholding, but it doesn't seem that many did. "We didn't hear a lot of that anecdotally," said Michael Lister, chief executive of the Jackson Hewitt tax preparation service.

People who make quarterly estimated tax payments "have the ability to reduce their estimated payments to get this number exactly right," and many did, said Bernie Kent of PricewaterhouseCoopers. But for many people with smaller payments "it wasn't worth the time to recalculate."

For many people, other new breaks will add still more to their refunds, but experts caution that, while filing early may be a good idea, no one should be in such a hurry that he overlooks some benefit.

Taxpayers "should take advantage of everything they got -- and they got a lot," said James Stivala, a financial planner with J.P. Morgan Chase.

For example, the 2003 bill increased the size of the 10 and 15 percent brackets for married couples filing jointly, and it boosted the standard deduction for married couples to double that of singles, reducing or in some cases eliminating the "marriage penalty" for two-income couples. The increase in the standard deduction won't help couples who itemize their deductions, of course, but it may enable some itemizers to take the standard deduction -- a much simpler return -- and be better off.

In addition, the bill increased the exemption amount allowed under the alternative minimum tax, a change that will spare some taxpayers the pain of paying the AMT, which was originally aimed at the rich but is now ensnaring a growing number of middle-class families. Essentially, the AMT requires you to do your taxes, then redo them without the benefit of certain deductions, such as state and local taxes, but using a big standard deduction (called the exemption amount) and different rates. You pay whichever tax -- AMT or regular -- is higher. Last year's bill boosted the exemption amount for couples to $58,000 from $49,000.

On the other hand, the new lower 15 percent rate for stock dividends could propel some taxpayers into the AMT who never had to worry about it before. "Those people who had income from dividends who never were even close for the alternative minimum tax now all of a sudden will be in" it, at least as long as taxes on dividends remain low, Kent said.

Then there is the per-child tax credit, which has lots of twists and turns. It was boosted to $1,000 last year from the $600 that had been in the law, and the Internal Revenue Service sent out checks for that extra $400 to taxpayers it figured would be eligible for the credit in 2003, based on their 2002 returns. Taxpayers who got such checks won't get the full credit now, of course, but those who have new children or were missed by the IRS for some reason can get the full $1,000. A credit reduces taxes dollar for dollar, in contrast to a deduction, which reduces taxable income.

This credit is partly refundable to some low-income taxpayers, meaning that if the credit exceeds their taxes, they get the difference back in cash, up to certain limits. It also phases out for higher-income taxpayers. The interaction of these limits and the advance payments is going to cause plenty of headaches, but for some taxpayers it may be a bit of a windfall. The law says the advance payment can't reduce the credit below zero, so those who got an advance payment and now find they aren't eligible may be able to keep some or all of it.

But headaches or not, when you add in all the breaks, said Lister, "the taxpayer is a winner this year."

Officials of the Treasury, IRS and the companies involved last week kicked off the second season of Free File.

Free File is a government-private partnership to allow lots of taxpayers to get their returns prepared online and filed free electronically. It has stirred controversy over its brief life, most recently over reports that the IRS intended to "flag" Free File returns, stirring concern that those returns would be selected for audit.

Last year "was a learning experience," said the IRS's Terry Lutes, and the program is greatly improved this year. No returns will be flagged, he said, but because the IRS needs to evaluate the program and can't do that without knowing which returns were filed via Free File, the agency is continuing to look for some way to do that without scaring people.

Taxpayers interested in using Free File can go to the IRS's Web site, http://www.irs.gov/, and click on the Free File line. Note that not everyone is eligible for free preparation and filing -- the program is supposed to cover 60 percent of all individual tax filers, and criteria differ from company to company -- so be sure you qualify before you invest a lot of time.