Why You Don’t Want a Large Income Tax Refund

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You may be thinking: I don’t lend my friends money, so why would I lend the government money…for free! Well maybe you are and maybe you’re not, so let’s dig a little deeper to make sure you’re not giving Uncle Sam an interest-free loan and then address how to handle it if you are.Ilovecompoundinterest.com, I love compound interest, tax savings, income tax filing, tax refund, income tax, tax penalty, W-4

One of the privileges of living in the United States is that we get to pay taxes (yes, that was sarcasm). I do love my country, but does anyone enjoy paying taxes? Many people have their federal income tax taken out of each paycheck according to what they have filled out on their W-4 form. Most of us have probably forgotten what we put on that form or you may have been pressured to just put down any number in order to get your new-hire paperwork completed. Do you know how many allowances you put down on the form? If you forgot, it may also be on your paystub, but frankly the way that the number of allowances gets turned into an amount out of your check is a bit of a mystery.

So why am I even talking about the W-4 if we’re supposed to be talking about not giving the government a free loan? It all has to do with income tax. The W-4 is the document that starts the ball in motion to have your taxes taken out periodically through the year via payroll deduction. Then each year by April 15th we have to complete our federal income tax forms to find out if we owe more tax or if we get a refund. A lot of media attention is given to tax refunds and I feel like our culture feels like it is an awesome thing to get a tax refund. People talk about it as if it is found money. News flash, it’s not found money, it’s your money! If you are getting a sizable tax refund, that just means that you gave the government an interest free loan for up to 1 year…and they won’t pay you interest!

I’ve heard people say, “that’s how I save money”. Even a bank will pay you a small amount of interest if you let them hold the money for a year, but Uncle Sam doesn’t even say “thank you”, much less pay you interest. Too many Americans use this as a savings tool and take their refund check and make a large purchase. I’m sure there are large purchases that you may need to make, but the retailers are masters at trying to convince you that you need to buy something new and shiny with that money. They want you to feel like you are flush with cash from your tax refund and that it is the perfect time to buy (or put a down payment on) that new TV, car, RV, boat, etc.

In a perfect world, you want to complete your tax forms and owe $0.00. That means that you paid exactly the amount you were required throughout the year. That’s pretty hard to do, so I’m OK to pay a little at tax time, because that means that the government gave me a free loan! Ok, I’m exaggerating a bit. If you owe too much in April, you may owe a penalty, but they are rather generous with the amount you can pay without incurring a penalty. According to the IRS website…”Generally, most taxpayers will avoid a penalty if they either owe less than $1,000 in tax after subtracting their withholding and estimated tax payments, or if they paid at least 90% of the tax for the current year or 100% of the tax shown on the return for the prior year, whichever is smaller.”

Could you get your tax refund each year and use it to invest? Sure, and that would be great and get you well on your way to building wealth. The problem is that in reality, that hardly ever happens. I’ve found it very rare for people to actually save/invest when they get an influx of money. Discipline is key, but the best way to establish discipline for saving is to set up a monthly draw that goes automatically into an account. And the beauty of having a monthly saving instead of a once per year saving (from a tax refund) is that you get gains throughout the year, benefit from dollar cost averaging, and if things went sour for you, you could even use those funds for an emergency. If you have to wait until you get a large refund at tax time, you might be in dire straits if an emergency comes up. Of course if you have an emergency fund already established, that’s a moot point, but I think you get where I’m going here. I’d rather have my money now instead of letting the government keep it and return some to me at tax time.

If you consistently get a refund on your income tax, I encourage you to go to http://www.irs.gov/Individuals/IRS-Withholding-Calculator and follow their instructions to find out how many allowances you actually need to put on your W-4. Then turn your modified W-4 into your company’s payroll department to adjust your paycheck. You won’t likely know how close to zero additional taxes you will be until the next April 15th, so if you need to tweak it some more, keep trying until you get it the way you like it. There’s no charge for filing the W-4.

Now that you’ve adjusted your allowances, go and invest the added money that you are getting in your take-home pay. I know you were used to a smaller check before you adjusted your W-4, so invest it now! Set up an automatic investment each month so it is drawn out routinely from your paycheck and you won’t feel the “pain” as much and you don’t have to try and remember each month to transfer funds to your saving/investment option.

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