A tax refund is usually held up as the shining light of tax season – the one glimmer of positivity in an otherwise cold and heartless process. It’s true that getting a big refund from tax returns provides instant satisfaction, and there are lots of fun and creative ways you can put that refund to good use.
But is getting a large tax refund actually a good thing?
While no one would argue against getting the biggest possible refund when filing your tax return, the glorification of a large refund is inherently flawed. In reality, getting a big check from the IRS can signal some crucial flaws in the way you approach the tax process – and may actually lose you money in the long run.
Why a Big Return is Bad News
Even though many people see a large tax refund as a fun windfall, it’s important to remember that the money you receive from your tax return is your money. After all, only people who let the government take out too much in taxes over the course of a year get a refund.
It would be like if you stashed away $20 every paycheck and then at the end of the year, you had $520. You wouldn’t be excited, because you’d know that was your money.
While many people use their tax refunds to pay off debt, save for an emergency fund or start a retirement account, others use it for shopping trips and blowout vacations.
Accountant Eric Nisall of AccountLancer said that while it’s good to put your tax refund toward responsible goals, it’s still not a good idea to aim for a refund. Not having access to their money year-round puts dents into many people’s personal finances. Some don’t put away money in their 401ks because they don’t have enough in their regular paychecks to set aside. Others miss out on possible investment returns they could be earning. And if someone uses their tax return to pay off debt, they’ve also paid additional interest that could have been avoided.
“There are two prominent reasons why I think everyone should aim to owe on their tax return,” he said. “People who are in debt or struggle to meet payment obligations: by having more money flowing to their paycheck they are in a better position to pay down their debt quicker and avoid drawing out the process and reducing the mounting interest charges which compound the situation. For contributing to retirement savings: the earlier you get money into a retirement account, the longer it has to work.”
How to Avoid a Large Refund
Even though some people think that it’s just luck whether you get a tax refund or owe money, the truth is that the IRS makes it easy to figure out how to determine your own return.
It all starts with the W-4, which is the form that most people fill out when starting a job. It’s where you tell your employer how much to set aside for taxes. The IRS has a withholding calculator on their website that allows you to plug information from your paycheck to give you a good estimate on what you should set your withholding on your W-4.
Even though most people only fill out their W-4 at the beginning of their job, there is no rule that prohibits them from changing it as often as they wish. If your filing status changes or you decide to change your withholding, ask your HR department if you can fill out a new W-4.
“Changing withholding could/should be done at various times: when the prior year’s return reflects a large refund; when going through a major life event such as marriage, divorce, having a baby, buying a home,” Nisall said.
“There is no rule that limits your ability to change your withholding,” Nisall said. “You can change it every week, or semi-annually, or anytime the situation calls for it.”
Consult a Professional
There are times when it’s helpful to have a professional advise you on your withholding strategy.
For people who are self-employed, you’re responsible for estimating your own taxes. In general, a good rule of thumb is to save between 25-30% of your income. A tax professional, especially one with experience with self-employed business owners, can help you figure out a more custom solution.
Other people who are traditionally employed might also benefit from an expert’s opinion. While a withholding calculator can help you estimate exemptions based on your pay stub, it cannot take into account various other deductions, businesses and streams of income you may have. If your tax return is notoriously complicated, a CPA or other accountant might be able to better advise you on how to set your W-4.
Getting a return is a welcome surprise, but it’s a habit you should avoid. You can adjust your withholding easily but don’t forget to create a plan for the extra money you’ll have in your paycheck. The point of changing your withholding is to put those funds toward debt, retirement savings or an emergency fund, and not just having some more fun in the sun!