So far in 2017, the IRS has issued over 106 million tax refunds, with an average amount of more than $2,700. This means that three-fourths of all taxpayers got money back from the IRS this year. While this may sound like a good thing, it may not be.
Here's why getting a tax refund might be a financial mistake -- even if you use it to save or invest -- and what you can do to avoid the same mistake this year.
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Why a big tax refund could be a mistake
In a nutshell, the problem with tax refunds is that many Americans see them as "extra" money.
However, the reality is that your tax refund is your own money that the government collected and held on to, interest-free, for months. If you get the average tax refund of $2,700 and get paid from your job biweekly, this means that each of your paychecks should have been about $104 higher. Instead, you effectively loaned this much money out of each paycheck to the U.S. Treasury -- interest-free.
One popular defense of tax refunds is that they're a form of forced savings. In fact, 79% of Americans who got a tax refund in 2017 said they would put the money in savings or use it to pay down debt. There are certainly worse things to do with your money, but there are better ways to force yourself to save. For example, why not set up an automatic transfer of $100 from every paycheck into an interest-bearing online savings account, or a retirement account like an IRA? The point is that forcing yourself to save is a good thing, but not when you aren't earning any interest or investment returns.
It's also important to mention that I'm not saying all refunds are a mistake. Rather, I'm specifically talking about refunds that come from having too much money withheld from your paychecks. On the other hand, if you get a big tax refund because you're entitled to a tax credit or major deduction, that's a different story. As a personal example, while I was attending graduate school, I got a nice refund check each year thanks to the Lifetime Learning Credit for paying tuition.
Check your withholdings, and adjust if necessary
The best way to make sure you don't get an excessive tax refund next year is to check your withholdings and make any necessary adjustments.
For example, if you were single and had no children when you started your job, but now are married with two children, the number of exemptions or "personal allowances" you initially claimed on your employment paperwork could be far too few. Worse yet, many people intentionally claim zero allowances on their W-4 form in order to get a larger tax refund, which we've seen is a misguided strategy.
If a similar situation applies to you, it might be a smart idea to call or visit your payroll department to update your withholdings. Doing so is usually a painless process, and you can familiarize yourself with the W-4 personal allowances worksheet ahead of time to make it even easier.
Of course, nobody wants to owe the IRS money at the end of the year, so don't just claim a bunch of allowances you're not entitled to. The goal is to have just enough money withheld from your paychecks to take care of your income tax obligations, but not much more. Having said that, if it's been a while since you've examined your withholdings, you might be surprised at the number of allowances that is appropriate for your situation.
The bottom line
I don't know about you, but I'd rather have an extra hundred or so dollars in every paycheck as opposed to a lump sum at the end of the year. This way, I can choose to use the money as I need it -- to pay down credit card debt, save for retirement, or build up my emergency fund, for example. If you received a big tax refund in 2017, it may be a smart move to check your withholdings and see if you're giving the IRS permission to take too much money out of your paychecks.
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