Tax season is an exciting time for anyone expecting a fat refund check from Uncle Sam. Whether you're paying down credit card debt or saving up for a summer getaway, it's fun to imagine all the ways you'll use that money.
But here's what gets lost amidst the delight of this influx of funds: The government isn't actually giving you money. You're just getting back your own money. Without interest. And that's a bad thing. Here's why:
You just gave the government an interest-free loan
"Most people think getting money back is a good thing, a windfall," financial advisor professional Douglas Boneparth told Bankrate. But the only reason why you're getting getting money back is because you overpaid Uncle Sam.
When you got hired, you filled out a W4 form, an Employee's Withholding Allowance Certificate. This form, which provides details about your dependents, told your employer how much money to withhold from your paycheck and send to the IRS on your behalf.
More often than not, getting a big tax refund means your employer is holding back too much money. Maybe this happens because you have a lot of deductions you may not have anticipated, or because you filled out the W4 form incorrectly or because your family has changed and you now have more dependents.
Whatever the reason, you've given the IRS an interest-free loan. Sure, the government eventually sends your money back. But in the meantime, you've suffered an opportunity cost from not having access to that cash.
There are smarter ways to use that money
The average tax filer will get a $2,840 refund check this year. Instead of loaning Uncle Sam nearly $3,000, you could have invested the money or used it to pay off debt.
Giving the IRS this much extra money is "a missed opportunity for something better," Andrew W. Ferraro, a certified financial planner with Strategic Wealth Partners in Ohio told CNBC.
If your refund is on par with the average and you adjusted your withholding, your paychecks would be bigger. If you overpaid $2,840 too much, you are paying around $237 per month more than you should.
Even if you had taken that money and instead put it in an online savings account at a meager 1% interest rate, you'd be $28.40 richer. That could buy you a nice steak dinner for one or pizza for the whole family. Instead you let Uncle Sam pocket the interest.
If you had put this money towards debt, you would have paid it off faster and paid less interest. Say you have a credit card balance of $2,000 at a 15.59% APR and you make a $50 monthly payment starting in January. You'd have a balance of $1,690.57 left after making 12 payments and would have paid around $290 in interest.
But what if you put an extra $237 a month towards the debt? Now, your payment is $287. Your debt would be paid off after just eight payments and your total interest paid would be $111.15. You just saved yourself $178.85!
Is it ever a good idea to get a big refund?
The only benefit of making extra tax payments is the extra money withheld from your paycheck serves as a kind of forced savings. Instead of a small amount of extra money in your paychecks, you get money back in a big lump sum and are more likely to do something smart with it.
"Using your tax refund wisely and directing it toward your financial goals might give you a little boost that can go a long ways psychologically, if not financially," financial advisor Jon Teran told CNBC.
Still, there are other psychological tricks you can use to stay motivated to be smart about your finances — without giving the IRS an interest free loan. Talk to HR about having a portion of your pay automatically deposited into a savings account. If you're working on debt repayment, set up an auto debit the day your paycheck hits your account.
Rethink your withholdings
If you're convinced getting a big refund is bad news, fix the problem by adjusting your withholding.
Be careful you don't withhold too little and end up owing taxes and penalties at the end of the year. Use Investopedia's step-by-step guide to calculate the correct amount of withholding so you owe nothing but don't end up with a fat refund check.
Once you know how much you need to send the IRS, let HR know to change your withholding. Then, set up automatic savings or debt repayment with the extra cash and enjoy the benefits of a bigger paycheck all year long.
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