See if this sounds familiar: You settle down in March each year with a fistful of papers with secret-code names: W-2, 1099, 1040. It's tax time! Whether your tools are a pen and printed forms or online tax software, you plug in what you earned and fill in your deductions. With anticipation, you do the math…
Voilà! You got a refund. This is good news, right?
Actually, that depends--on how you got it, and what you do with it.
What is a tax refund?
Each year, you owe taxes to the federal government based on a number of factors: the size of your income, whether you're married and have children, whether you have a mortgage…the list goes on and on. Because the government doesn't want to wait a whole year for your tax money, you pay taxes throughout the year, either out of your paycheck at work (called "withholding") or, if you're self-employed, through taxes you send in yourself.
When you file your tax return at the beginning of the next calendar year, the amount you prepaid is compared with the amount you actually owe. If you paid too little the previous year, you have until April 15 to mail the Internal Revenue Service a check.
However, if you paid too much the previous year, the IRS returns your money. You may welcome that bounty as a gift rather than what it is: a sign that you willingly gave more than necessary the previous year.
Pros and cons of tax refunds
Let's say you receive a refund of $1,000. If you are paid twice a month at your job, that's roughly $40 out of each paycheck. That's $40 you could have used to pay bills or put into your savings account. That money could have been earning interest for you rather than being held interest-free by the government.
Does $1,000 sound like a lot? The average individual tax refund is about $2,900, according to the IRS Tax Stats at a Glance. That's $241 a month!
You may welcome this annual windfall as a "forced savings" plan, meaning that because you didn't see that money through the year, you weren't tempted to spend it. An annual tax refund can help you along the path to financial security as long as you use it to help achieve a financial goal such as paying down credit card debt.
But if you're getting the hang of a budget and getting started on your savings, you could be putting that extra money to good use every month, saving you interest on your debt and earning you interest at the bank.
Milestones can change the size of your refund
Maybe you were surprised this year by a bigger-than-expected refund. A major change in your life can trigger big tax savings. Did you:
- Buy your first home?
- Have a baby?
- Start a retirement fund?
These changes, and many others, can decrease the amount of tax you owe. If you continue to have the same amount withheld from your paycheck, you may be paying too much, giving up money you may need through the year for life's new expenses. It can make sense to keep more of that money for yourself during the year, rather than getting a big payout the following spring.
Increase your paycheck with a quick change
If you decide to trade in a big refund for a larger paycheck throughout the year, you can change the amount of tax withheld from each paycheck. Not sure how much to withhold? The IRS website includes a withholding calculator for taxpayers with traditional employers. Use recent pay stubs and your last tax return to fill in the calculator.
Next, talk to your company's payroll manager or human resources administrator. You will need to complete a new W-4, the Employee's Withholding Allowance Certificate. This form is used by your employer to determine what amount of taxes to withhold from your paycheck.
Tuck extra income into a savings account
Whether you choose to have a bigger paycheck throughout the year or you prefer the payout the following spring, use the extra cash to increase your financial security. Open a new savings account, build your emergency fund or pay down your bills.
A tax refund may not be a gift from Uncle Sam, but it can still give you the gift of better finances!