When you’re expecting a big refund, tax filing day can feel more exciting than your birthday. Last year, the average tax refund was over $2,800—that’s a big payout, and who wouldn’t be thrilled to look forward to the federal government depositing a huge chunk of change like that in your bank account?
Here’s the thing. When you get a big income tax refund, that means you’re not optimizing the tax withholding coming out of your paycheck. That refund you’re getting back is money you’ve been loaning the IRS interest-free all year.
The ideal situation to end up in at tax time is for you and Uncle Sam to be more or less squared up—neither of you owing much money to the other. If you don’t withhold enough from your paycheck, you can end up owing a big tax bill, and nobody wants that. Fortunately, this is a situation you can easily avoid.
Few of us are born with a desire to dig deep into the intricacies of tax withholding strategies, but if you take a little time to set it up right and adjust when necessary, you can get more money in your paycheck every month and not have to worry about paying a lot at tax time. You might miss that big lump sum refund, but there are smart ways to put that extra take-home pay to use that can have a big positive impact on your financial health.
Like Junk Food, Tax Refunds Are Fun – But Bad For You
A big refund means that, with every paycheck you’ve received, you’ve been sending the government a bunch of money that you didn’t actually owe them. You know that any time you take a loan out—for a car, a house, a credit card—you have to make interest payments to the loan provider. So, why are you letting the government borrow your money for free? Practically anything else you did with that money would benefit you more than letting the government hold on to it – even a no-frills savings account would earn you some interest.
The other drawback to big refunds is the tendency to see it as “free money,” and budget it as such. If it feels like a windfall, you’re probably going to spend it like a windfall. While we all enjoy vacations, new electronics, and bottle service, you could probably think of smarter ways to use that money—ways that will end up making you even more financially secure in the long-term, rather than spending it as soon as you get it.
You’ve Decided To Stop Loaning The Government Money—Now What?
Once you’ve committed to cutting the IRS off from your free loan program, what can you do to achieve that perfect state of tax zen, one where you don’t owe them and they don’t owe you?
The first thing to do is to compare your past tax returns to see, on average, what you’ve typically been getting back each year. Major life events and unusual financial situations can have a big impact on your taxes, so you want to make sure any changes you make are based on a normal, average year.
Next, you want to review the W-4 forms you file with your employer. This form determines your tax withholding based on your personal allowances, spouse, dependents, and filing status. The more allowances you have, the less money that will be withheld. If you’re getting too much of a refund, adjusting the number of allowances will go a long way toward fixing that.
Optimizing your allowances can be tricky, so this can be a situation where it’s worth it to sit down with a tax professional who can walk you through it and set up a personalized plan for you.
What Are You Going To Do With All This Extra Money?
Once you start getting extra money in your paycheck, you’re going to want to use it wisely. It’s easy to put that extra cash right into your disposable income bucket, but if you can allocate it toward something with long-term benefits before you get used to having it, you’ll be doing yourself a huge favor. You could:
- Put it in a savings account with compound interest
- Invest – there are apps like Acorns that make it easy
- Increase contributions to your IRA or 401k plan
- Pay off debts faster
All of these things can set you up for a stronger financial future. Letting the IRS hold on to your money doesn’t.
Your Money, Your Future
It’s exciting to anticipate getting a big refund and think about all the fun ways you can spend it, but ultimately, that big refund means you haven’t been making the most of your hard-earned money.
A meeting with a tax professional can help you get your allowances and withholding set up correctly, and you’ll have more money every month that you can put to good use by saving, investing, and reducing your consumer debt. That may not sound as exciting but future you will be incredibly thankful you got smart about taxes early on.