Many people dread tax season for obvious reasons. But, there are others who look forward to this time of year because of two important words: tax refund.
Those who anticipate the arrival of their tax refund usually know that they’re in for a big, nice check from the U.S. government. However, a bigger tax refund isn’t always a good thing.
What a Huge Income Tax Refund Really Means
Getting your money back from the federal government during tax season in one lump sum might seem awesome. But the truth is it can be detrimental to your savings account. Why? Simply put, being owed a big tax refund means you’d been overpaying Uncle Sam the entire year.
Still don’t see anything wrong with this concept? Consider the following scenario:
A colleague asks to borrow $15,000 from you. You’d likely charge them a percentage of interest in addition to the principal amount borrowed, even if this hypothetical borrower had an outstanding credit history — after all, you’re doing him a favor and would like to balance the risk with some kind of return.
The same scenario plays out when depositing money into an interest-bearing savings account at a bank. Your physical cash never truly stays in a safe with your name on it; rather, banks use your deposit as a temporary loan with the promise to pay it back, plus interest. In the end, the sacrifice you make in parting with your funds temporarily is compensated with interest earnings.
So, when too much of your wage income is withheld for federal taxes, you’re giving away an interest-free loan to the government without receiving anything extra in return. Then, when a hefty tax refund is sent your way after you’ve filed your tax return, it’s a sign you’ve been duped.
This realization might leave you with bitter feelings of betrayal, but there’s an easy way to ensure that you’re witholding the right amount of income from your paychecks.
Federal Income Tax Withholding Allowances
The amount of income tax that is taken out of your gross pay depends on your salary and the information you entered on your W-4 form upon being hired by your employer.
According to the IRS’ Publication 505 Tax Withholding, factors that employers use to calculate how much of your pay is taken out for federal income taxes include:
- Marital status (e.g., single, married, married but withhold at higher single rate)
- How many withholding allowances you are eligible for and want to claim (the higher the amount, the less is withheld from your pay)
- Any additional amount of your income you want withheld
- If you want to claim an exemption from withholding in 2016
The tax refund issue arises when taxpayers convince themselves that paying more taxes than what is owed is a safe bet against owing money after filing a tax return. For this reason, they claim the smallest withholding allowance of one or even zero.
However, by correctly filling out your W-4 with the correct number of allowances, you can both pay your due to society via federal income taxes — and help your savings account.
Why a Smaller Tax Refund Is Better for Your Finances
There are many ways reducing your tax refund by adjusting withholding allowances can help grow your savings account and improve your finances overall. Here are a couple benefits of a smaller refund:
- Ability to earn more money. Instead of giving an interest-free loan to the government, you can allocate the extra take-home cash from your paycheck into an interest-bearing account throughout the whole year. While deposit rates are still relatively low, online banks offer competitive rates that can earn you more with little risk involved.
- Better money management. A common argument against reducing tax refunds is that extra access to cash incrementally throughout the year will just lead to spending instead of saving. However, having a more accurate and consistent view of your budget and finances — rather than a sudden flood of income via a big tax refund during tax season, which will likely be blown anyway — leaves you in a better position to refine your money management skills year-round.
- Control. By having access to your money throughout the year, you can use it or save it as you see fit. There is no invisible obstruction keeping you from using money you’ve earned to pay for routine car maintenance or on nights out with friends. Ultimately, you’re accountable for how your money is used.
A massive tax refund can feel like Christmas Day revisited, but understanding what a large refund really means opens the door to great savings potential in the long term.
Keep Reading: 13 Worst Things to Do With Your Tax Refund