Millions of taxpayers look forward to getting a tax refund every year. But are tax refunds a good thing or a wasted opportunity?
Every year as tax season rolls around, millions of Americans can’t wait to file for their taxes in anticipation of their big “bonus” check. In fact, there were 31,937,000 refunds issued in the 2019 filing season, totaling $101.212 billion. The average refund amount was $3,169. If you’re seeing these numbers and thinking “Wow, that’s great!” you may want to think again.
What is a tax refund?
The fact that you’re receiving a tax refund means that you may have overpaid the IRS throughout the year. If you did, that also means you lent money to the government interest-free. Had you not overpaid on your taxes, you could have had that money allocated elsewhere, earning interest or saving you interest.
While the excitement of a large lump sum at the beginning of the year may be tempting, we’re offering another way to look at your taxes and how making some changes could actually add more money to your pocket.
Why getting a tax refund sucks
If Uncle Sam is writing you check every tax season, it’s not because you’re getting a special bonus – you’re being refunded the money that you overpaid. You’re simply getting your money back, and the worst part is, it may be worth less than what it was when you lent it to the government thanks to inflation. For example, using the CPI inflation calculator you can see that $3,169 in December 2018 had the same buying power as $3,241.42 in December 2019.
Overpaying the government money throughout the year does you no favors. Consider that, according to a recent study by Fidelity, the top three financial concerns for 2020 are unexpected expenses, personal debt and not saving enough money for short and long-term needs. Those tax dollars you’re having withheld could help you quell these worries throughout the year.
The bottom line is, if you’re regularly receiving sizable tax refunds, it might be time to start rethinking your tax strategy so that you can make savvier financial decisions.
How extra income could be better used throughout the year
The extra income that you’re currently loaning to the government throughout the year in the form of paycheck deductions might be much better used. Here’s how:
Build an emergency fund
Instead of overpaying in taxes each paycheck, you could use that money to build up an emergency fund, which would help solve the number one financial concern of 2020 – unexpected expenses. By having an emergency fund at your disposal, you’re better equipped to cover unforeseen costs– like a flat tire or broken water heater– without going into debt. This allows you both peace of mind and financial security.
Pay off debt
Another alternative is to pay off some of your debt, which solves the number two financial concern of 2020. If you have personal loans or credit card debt, you can use your tax refund money earlier to pay them down. According to the average refund amount, this could allow you a few hundred dollars each month to make extra payments on your debt principal which will save you on interest.
Save for retirement
The third concern for Americans in 2020 is saving for the future. Pay yourself first. Take the extra income you’ll have each month by not sending your money to the IRS and put it into your retirement fund where it can earn interest.
As you can see, by rethinking your tax strategy, you can solve and prevent some of the most pressing financial concerns for 2020.
Pros and cons of overpaying taxes
Here’s a rundown of the pros and cons of getting a tax refund. Keep these in mind as you evaluate and determine your tax strategy this year.
Here is a list of the benefits and the drawbacks of getting a tax refund
- Receive a lump-sum of cash in a tax refund.
- Overpaying taxes is like forced savings which can help people who have trouble saving.
- Reduces the risk of underpaying your taxes.
- You’re giving the government an interest-free loan.
- You could be using the money to pay down high-interest debt
- You could be investing the money and earning returns.
Take some time to weigh these pros and cons against your financial situation and decide what makes more sense for you.
How to fix the problem
If you’re only receiving a small refund check every tax season, there’s probably no reason to head to HR and make any changes right now. That said, if you’re repeatedly receiving a refund that’s closer to the national average of $3,169, you should consider making a change.
The best way to figure out your optimal withholding is to use the IRS’s withholding calculator. All you need to use this tool is your most recent paycheck and your last tax return so you can enter the necessary information and determine your withholding. Once you have this number, you can then file a new W-4 with your employer with your new tax information. After that, you can expect to see more money in your paycheck.
The bottom line
There are two different ways to look at your tax setup/refund. While it can be exciting to receive that lump sum of cash at the end of the year, it’s important to also understand that the money you’re receiving is often due to an overpayment throughout the year. If this is the case for you, be sure to consider your other options.
If you’re someone who has no debt, no interest in investing, and trouble saving money, you may find that a larger tax refund works well for you because it works as an automatic savings plan. However, there are better ways to save money and actually earn interest, like a CD which requires you to keep your money in it while earning interest. No matter what you decide, it’s always in your best interest to be informed about what your options are so that you can make choices that make the most financial sense for you.
Jessica Walrack is a personal finance writer at SuperMoney, The Simple Dollar, Interest.com, Commonbond, Bankrate, NextAdvisor, Guardian, Personalloans.org and many others. She specializes in taking personal finance topics like loans, credit cards, and budgeting, and making them accessible and fun.