A Tiny Tax Refund Could Be the Best Thing to Happen to Your Finances
When you finish filing your income tax return, you’re probably looking forward to getting that refund check. And the bigger the better, right? Well, no. In fact, getting a big tax refund might be a very bad money move.
In order to make the most of your money, you’ll need to understand why you shouldn’t receive a tax refund.
Why Is Getting a Large Refund a Bad Thing?
To understand why a large tax refund is bad, you need to know that when you get a tax refund, the government is returning some of the money it withheld from your paycheck throughout the year. That’s right — the federal government took too much money from you all year long, and when it sends you a refund, it’s just giving it back. It’s not giving you extra money. The IRS paid over $452 billion in refunds for fiscal year 2019. That’s a lot of taxpayer money it’s been holding onto.
In effect, American taxpayers gave the government an interest-free loan of over $452 billion. If you’d rather not loan the government your money for free, you can get a smaller refund by having less money withheld from your paycheck.
How to Better Use Your Money Than Overpaying in Taxes Just to Get a Refund
If you have less money withheld, you’ll get more money in each paycheck. You can save or invest this money so that it earns you even more money. And if you like to spend your tax refund on something special, you would be better off saving that money in an interest-bearing account and taking it out at tax time to splurge.
Many taxpayers still say they’d rather get a big check rather than a little more in each paycheck. They like the idea of getting all that money at one time. Or, they’re afraid they’d spend that smaller amount every week without noticing it, so they use their withholding as a savings account of sorts. But with direct deposit, you could have that money deposited into a separate savings account where it would earn interest and you would end up with more money at the end of the year.
How Do I Know if My Refund Is Too Large?
The average tax refund in 2020, for tax year 2019, was over $2,500, according to the IRS. That means the average taxpayer who gets paid twice a month could take home over $100 more in each paycheck if they had the government withhold the correct amount from their pay.
If your tax refund is too high, you can change the amount of money withheld from your paycheck, which will control the size of your refund. The less money you have withheld, the more money you’ll get in each check, and the smaller your tax refund will be. Use the withholding calculator on the IRS website to help determine the right amount. You’ll need recent pay stubs for yourself and your spouse, if you are married, records of other income you receive and your most recent tax return.
If your income varies or you have a complicated tax situation, you might want to consult IRS Publication 505 or a tax advisor to determine the right amount of withholding for your particular situation.
Ultimately, only you can decide if your refund is too large. But you can adjust your withholding amount so that your refund is appropriate for you.
Still Getting a Refund? 20 Smart Things to Do With Your Tax Refund
How Do I Adjust My Withholding?
If you find that too much or too little tax is being withheld from your pay, it’s easy to change it. You tell the government — through your employer — how much to withhold based on things like your filing status and the number of dependents you have. It can also be affected if you have more than one job.
To change your withholding, you need to fill out a Form W-4 and give it to your employer. Your employer will adjust the amount that comes out of your paycheck each pay period for income taxes. If you change your withholding amount during the year, you’ll want to check it again at the beginning of next year to be sure it’s still correct. It’s also a good idea to check it again when there are changes in the tax law.
The IRS has revised Form W-4 for 2020, doing away with withholding allowances, which were essentially rendered moot when the IRS eliminated personal exemptions. In place of the allowances you’ll find new entries for income from other jobs, the number of dependents you have and the amount of itemized deductions you claim. The new form should result in more accurate withholding because it factors in a more precise picture of your tax situation.
Although you won’t be required to fill out the new W-4 unless you change jobs, you might consider doing it if you itemize deductions, claim tax credits or have nonemployee income from self employment. Consult a tax professional if you have a question about whether one-time credits, such as the recovery rebate credit you’ll claim if you didn’t receive your full payments for the first and second rounds of stimulus, might warrant a new W-4.
You should also consider filling out the new W-4 if you have a change in your situation, like getting married, having a baby, a change in your spouse’s working status or getting a second job. And if you find you’re still getting a larger refund than you’d like or you end up having to pay the IRS at filing time, adjust your withholding again.
So, what can you do with the extra money you get in each paycheck? The same thing many people do with their tax refunds, like pay off debt, or save or invest it. You could even take that annual vacation if you want. The difference is, you can do it sooner because you don’t have to wait for the IRS to process your return and send your refund. And you’ll probably have a little extra money from the interest you earned.
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Daria Uhlig contributed to the reporting for this article.
Last updated: Feb. 12, 2021