In the first tax season since the pandemic payments stopped coming, the theme for 2022 must be that bigger tax refunds are always better, right?
According to a new study from GOBankingRates, nearly 28% of the taxpaying public expects to get no refund at all this year or a small refund worth $500 or less. Believe it or not, they’re probably in much better shape than the nearly 16% who expect a windfall of more than $3,000.
In fact, if you do get a jumbo refund from 2021, not acting now to shrink or eliminate next year’s refund could be the worst financial move you make all year. Here’s what you need to know.
Why Is Getting a Large Refund a Bad Thing?
When you get a tax refund, the government is returning some of the money that your employer withheld from your paycheck on your behalf throughout the year. That’s right — the federal government collected too much money from you all year long, and when it sends you a refund, it’s just giving back the difference. It’s not giving you extra money.
The IRS issued more than $736 billion in refunds for fiscal year 2020. That’s a whole lot of money that was steered around the checking accounts of the people who earned it and into the government’s coffers.
In effect, the American taxpayer gave the government an interest-free loan of nearly three-quarters of a trillion dollars. 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 keep more money in each paycheck. You can then save or invest this money so that it earns you even more money. If you don’t think it matters because you like to splurge your tax refund every year anyway, you would be better off saving that money in an interest-bearing account and taking it out at tax time to indulge yourself.
Some taxpayers might be perfectly aware of why they get a refund, but would still prefer the big lump-sum payment instead of slightly larger paychecks throughout the year. In other cases, they might be afraid that they’d spend that smaller amount every pay period without noticing it, so they use their withholding as a savings account of sorts. Here, too, the smarter move is to keep the entire paycheck and set up a recurring auto-transfer that puts whatever amount the IRS would have taken directly into an interest-bearing savings account.
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How Do I Know If My Refund Is Too Large?
As of late February, the average refund so far for tax year 2021 is $3,536 — that’s $700 more than last year’s average refund, according to CNBC. That means the average taxpayer who gets paid twice a month could have taken home over $147 more in every paycheck if their employer had withheld the correct amount of money to deliver to the IRS.
If your tax refund is too high, you can decrease your tax withholdings to reduce 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.
Just keep in mind that if you reduce your withholdings too much, you’ll end the year with an outstanding balance and the IRS will come to collect with a tax bill when you file your returns.
How Do I Adjust My Withholding?
Your employer withholds your estimated tax payments from your paycheck and sends them to the IRS on your behalf. Those withholdings used to be calculated based on your income, filing status, and withholding allowances. But in 2020, the IRS completely revamped the process, did away with allowance numbers, and redesigned Form W-4, which you must submit to your employer to change your withholdings.
To get started, gather your pay statements, information about any other income you earn, and your most recent tax return and use the IRS’s Tax Withholding Estimator tool to walk you through the process.
You should also consider using the tool if you have a change in your life circumstances, like getting married, having a baby, experiencing 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 withholdings 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 big 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 hopefully have a little extra money from the interest you earned.
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