Got a Huge Tax Refund? Here's Why You Don't Want a Repeat Next Year
If you're among the millions of Americans who came away with a tax refund this year, you might already be dreaming of the things you'll do with that money. But before you get too deep into celebration mode, here's a small reality check: Getting a tax refund -- particularly a large one -- isn't actually a good thing at all. And the sooner you recognize that, the better equipped you'll be to avoid a repeat come this time next year.
When money back isn't a good thing
As my colleague Matthew Frankel reported in February, the average American tax refund in 2016 was $2,860 -- not exactly pocket change. All told, over 70% of 2015 tax returns resulted in refunds totaling more than $317 billion. That's a lot of money to lend the IRS for nothing in return.
IMAGE SOURCE: GETTY IMAGES.
The problem with tax refunds is that they're widely regarded as free money, when in reality, they represent earnings that didn't actually need to be withheld in the first place. Now this wouldn't be such a large problem if most Americans were financially sound. But given that most of us are sorely lacking in emergency savings (heck, 69% of the population has under $1,000 in the bank), not having access to that cash up front leaves countless workers perpetually strapped.
Say you're living paycheck-to-paycheck when you encounter a $2,000 bill you can't pay. In the absence of savings, you'll have no choice but to put that bill on your credit card and rack up interest charges as you (hopefully) pay it off over time. Now let's assume it takes three years to knock out that debt at 16% interest. After all is said and done, you'll have lost about $530 to interest charges. On the other hand, had you been collecting that extra money in your paychecks all along, you might have managed to pay off that bill in six months' time, cutting your total interest charges to just $94.
Remember, wealthy people are less likely to get tax refunds than lower earners who need it the most. According to IRS data from 2012, 84% of taxpayers earning under $25,000 a year received refunds, compared to just 34% of workers making more than $200,000. Even worse, the average refund that year for lower earners was $2,086 -- a sizable chunk of cash to part with when you're barely able to make ends meet. Even if you're not a particularly low earner, having that cash unnecessarily withheld could spell trouble for your finances -- so why let it?
How will you spend your refund?
Here's another problem with tax refunds: Because people tend to adopt that "free money" mentality, many inevitably blow that cash on nonsense rather than use it responsibly. After all, it's money they never expected to come by, and therefore, it's theirs to spend. In fact, last year, 16% of people who got a refund said they planned to use the money to splurge on a purchase or take a vacation. And that's all fine and good if you have adequate savings and no bad debt. But since most Americans can't claim either, getting a refund opens the door to even more reckless financial behavior.
Breaking the cycle
If you're tired of cheating yourself out of your own hard-earned money year after year, it's time to put an end to that pattern. First, examine your W-4 and adjust your withholding as necessary. You can use this helpful calculator to figure out what to claim.
Next, safeguard yourself from the opposite scenario -- underpaying your taxes to the point where you owe the IRS a chunk of cash next year. While I'll be the first to argue that it's always better to owe money than get money back, it can also be a blow to folks without savings. To avoid a problem, take whatever additional cash you get your hands on after adjusting your withholding, stick it in a separate savings account, and pledge not to touch that money unless a true emergency strikes. If, come tax season next year, you find that you do owe a bit of money, you can tap that savings account to pay the IRS. And if you don't end up owing money on your taxes, that additional cash is yours to keep and spend as you see fit (though I'd still advise you to use it responsibly).
Unless you're a firm believer that the government deserves access to your money more than you do, you'd be wise to break the cycle of getting a refund every time you file your taxes. You're far better off collecting what's yours and using it wisely.
The $16,122 Social Security bonus most retirees completely overlook If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,122 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after.Simply click here to discover how to learn more about these strategies.
The Motley Fool has a disclosure policy.