You may have seen commercials or ads featuring happy families wearing leis around their necks, men checking out big-boy toys or women clutching multiple shopping bags with labels like Burberry or Saks Fifth Avenue – all courtesy of a big income tax refund from Uncle Sam.
The average federal income tax refund is indeed substantial – a hefty $2,700 for 2012 and $2,790 for the first quarter of 2013, according to the IRS. However, those checks are not actually the bonanza that commercial tax return services would have you believe. In fact, if you consistently receive large income tax refunds, you should seriously consider making major adjustments in the way you think about–and pay–your taxes.
Everyone knows that getting a tax refund sucks.
Interest Free Loans to the Government!
That check you’re so happy about getting each year? It’s actually your own money. Worse, it’s money that you have lent to the federal government (or to the state) interest free. Odds are you have never received an interest-free loan from anyone outside your immediate family or close circle of friends. Yet every year, millions of Americans willingly provide Uncle Sam or their state governments with a twelve-month loan with zero interest. The reward they receive for their generosity is – wait for it – getting their own money back.
It doesn’t sound so great when you think of it that way, does it?
Inflation and Your Shrinking Dollars
As of this writing, inflation is low, but it isn’t nonexistent. This means that the money that you receive back from the IRS is worth less than it would have been if you had been able to spend the money at the time that you earned it. For instance, according to inflation calculator available through the Bureau of Labor Statistics website, that $2,700 income tax refund many Americans received in 2013 is equivalent to $2,711 in 2014 dollars. Perhaps $11 isn’t enough to stress over, but if the rate of inflation goes up, the impact could become considerable in later years.
Making the Proper Adjustments
Many people hesitate to lower the tax deductions taken from their paychecks because they don’t want to owe money at tax time. Others want to avoid hefty underpayment penalties. Both are legitimate concerns, but concerns that are easily dealt with. You can estimate the proper amount of income tax to have withheld from your paycheck by using the IRS Withholding Calculator, available through the IRS website. If you need to make adjustments based on the results of the calculator, simply submit a new W-4 form to your employer.
The forms are available for free download through the IRS website and can be submitted at any time during the year (or even multiple times per year if your income fluctuates). You also need not worry about paying a penalty on any income tax that you may end up owing to Uncle Sam if any of the following three situations apply to you:
- You owe less than $1,000
- You paid at least 90 percent of your tax liability before filing your 2014 tax return
- You paid at least 100 percent of what you owed in federal income taxes for 2013 (or 110 percent of your 2013 tax obligation if your income is $150,000 or more)
If You Still Want That Tax Refund
Some people use tax refund checks as a form of forced savings, which is understandable. Nonetheless, if you truly are committed to establishing a savings fund for a big vacation, your retirement fund or for some other reason, try this strategy instead: divide the amount of your previous year’s refund by the number of paychecks you receive each year. Place the resulting amount in a savings account with every paycheck.
Once you have collected enough money in your savings account, make a withdrawal to purchase a certificate of deposit or other financial investment instrument. Rinse and repeat with each paycheck throughout the year. If you stick to “safe” investments, you won’t risk losing your hard-earned cash, and odds are that you will have accumulated more money at the end of 12 months than you would have received from a refund check.