The Massive Tax Refund Mistake Millions of Americans Are Making

By Sean Williams Markets Fool.com

We're entering the heart of tax season, which for many Americans is a bittersweet period.

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On one hand, tax time means an arduous and potentially time-consuming walk down our financial past. The Internal Revenue Service estimates that a cumulative 8.9 billion hours will be spent complying with federal tax laws for 2016, while the Tax Foundation finds that the U.S. tax code has now eclipsed 10 million words! It's no wonder that most consumers dread preparing their taxes, even with the help of tax software or a tax professional.

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Then again, tax time also means a big payday for most Americans. IRS data consistently shows that more than 70% of tax filers receives federal refunds, which most years tends hover around an average of $3,000, plus or minus 10%. Netting a refund of $3,000 can have huge implications for the average taxpayer or their family in terms of paying down debt, building up an emergency fund, or adding to a nest egg.

Here's what Americans plan to do with their federal tax refunds

With so many Americans expecting to receive federal tax refunds, it's only natural to wonder what they plan to do with their extra cash this year. This was the recent motivation behind GoBankingRates' tax refund survey, which aimed to find out where those billions of dollars would be headed in a matter of months.

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GoBankingRates asked 1,000 respondents the following question: "What do you plan on doing with your tax refund?" The respondents were then given seven possible answers, with only one response permitted:

  • Pay off debt
  • Splurge on a purchase (e.g., television, apparel)
  • Put money toward a vacation
  • Put the money in savings
  • Make a major purchase (such as a car or house)
  • I did not receive a tax refund
  • None of the above

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Among those Americans who are receiving tax refunds (and were decisive in their choices), just 5% suggested that they would be making large purchases, with another 5% expected to splurge on smaller purchases. Another 11% expected to put the money toward vacations. However, the bulk of Americans expect to either put their tax refunds into savings (41%) or pay off debt (38%).

This variety of answers is exactly what we should be seeing given the poor saving habits of Americans and their high levels of debt. Previous GoBankingRates surveys have shown that nearly 70% of Americans have less than $1,000 in emergency savings, and that the median amount of credit card debt and student loan debt is around $2,000 and $9,000, respectively. The average American has a number of obstacles to tackle, and it would appear, at least based on this latest survey, that taxpayers are taking saving money and paying off debt more seriously than they have in the past.

The major tax refund mistake millions of Americans are making

While taxpayers clearly intend to put their refunds to good use, millions of taxpayers also happen to be making a pretty big mistake that's costing them the ability to pay down their debt faster and earn more with the money they do save.

As we know from IRS statistics, more than 70% of tax filers will receive a federal tax refund in a given year. Though a refund might seem optimal for most folks, it's actually a poor use of your own money. Allowing the federal government to hang onto thousands of your own dollars on an interest-free basis for months, or potentially longer than a year, only winds up hurting you in the pocketbook.

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There are a few possible exceptions here. For instance, if you're an impulsive shopper and you struggle to save money, the forced savings provided by a fat refund check can be worthwhile, assuming you take that money and immediately invest it or use it to pay down debt.

However, most taxpayers have no excuse for allowing the federal government to hang onto their cash for extended periods of time on an interest-free basis.

A simple fix

The good news is that there's an exceptionally simple solution: adjust your federal tax withholding via Form W-4. Your federal tax withholding is what dictates to the federal government how much of your income should be withheld with each paycheck. If you regularly owe money to the government, you should adjust this figure higher. If, however, Uncle Sam owes you a lot of money each year, this figure should be moved lower, which would have the effect of increasing your paychecks throughout the remainder of the year.

Now, I know what you might be thinking: "I get the same amount of money either way -- whether I split it up throughout my paychecks or I take a large refund come April." While it's true that your tax liability isn't changed (all things being equal), the impact you can have with your tax refund certainly changes.

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For example, credit card and student loan debt gather interest with each passing day and/or month. Waiting a year or longer to get your tax refund means allowing that interest to unnecessarily accrue. Instead, you could be boosting your paychecks each and every month and whittling down your credit card and student loan debt much faster.

Similarly, why give Uncle Sam the ability to hang onto your cash without paying you a cent in interest when you can be taking that capital and getting a head start via an investment account?

Taxpayers have the right idea when it comes to wisely using their tax refunds. The next step is in getting them to realize that netting a huge refund shouldn't be the goal at all. If you're regularly owed a refund, I'd suggesting aiming for as close to a $0 refund as possible. If you do, you'll probably find that your debts will disappear faster, and your nest egg will grow with a little extra pep given the additional cash you'll be pocketing with each pay period.

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