Why a Tax Refund Is Bad Personal Finance

Managing your tax withholding correctly lets you grow your money in your savings account rather than hand it over to Uncle Sam as an interest-free loan.

There's nothing like the feeling of a big tax refund. Getting that check in the springtime is a breath of fresh air after the long, expensive winter months. It's as if the Universe saw your dwindling bank account as you wrote check after check to pay for heat, winter clothes, and indoor activities, and now, poof, you've been handed free money.

Getting a tax refund feels so good that many people deliberately overpay their taxes during the year so they can get that fat check in April. It's certainly a better feeling than discovering you owe the government a large sum of money you hadn't anticipated.

Your Tax Refund Isn't Free

That money isn't free, though.

It's your money that you've given Uncle Sam as an interest-free loan for a year. The government invested those dollars, earning interest on them, while you were juggling your pennies.

When you're living with financial blinders on, that refund check really seems like a gift. Your taxes were withheld from your paychecks all year without you doing anything. If you're like a lot of people, you rarely look at your paystubs. You probably don't even know how much is being withheld. You filled out a form a long time ago with some vague numbers about how many kids you have, and the company did the rest.

Since you never felt the pinch of that money going out, it's just gravy when it comes back in.

The truth is, though, that you've been overpaying your taxes. That's money that could have been going into your savings accounts all year long, earning money for you instead of the federal government. Yes, you get back whatever you overpaid. But you've lost the interest you could have earned on that money.

If the government asked you to give them a no-interest loan in the amount of your tax refund, you'd probably say no, right?

How to Pay the Right Amount on Your Taxes

You don't want to loan the government your money, but you also want to avoid underpaying your taxes. That can result in a big bill come April--and that's an irregular expense that may throw off your planning.

To adjust your withholding to more closely match what you actually owe, you want to fill out a new W-4 form with your HR department or whomever handles the withholding. This form from the IRS can help you strike the right balance between too many exemptions and too few, so your tax withholding gets close to what you owe. Tax rates haven't been set yet for 2011, but here are projected 2011 income tax rates.

If your income varies a lot throughout the year, you'll want to revisit your W-4 more than once. April and November are good times to check in and see if your tax withholding is on track with your actual tax burden. You'll also want to fill out a new W-4 if:

• You got a big refund last year
• You owed over $100 last year when you filed your tax return
• You got married or divorced
• You had a child
• You can no longer claim a dependent that you claimed last year

If you're self-employed or run a small business, your taxes are more complex. You're probably already paying close to what you actually owe, because you pay quarterly estimated taxes based on the net profit your business makes each quarter.

Saving the Money Yourself

The one upside to a tax refund is that you get a lump sum of money that's been saved out of your paycheck throughout the year. If you're living paycheck to paycheck, it can seem impossible to save that money yourself. It's not impossible, though: the money was already being taken out of your check.

When you adjust your withholding to better reflect you actual tax burden, be sure to put the newly available money directly into savings account. For an extra tax bonus, put those dollars into your tax-advantaged 401(k) or IRA accounts, if you're not fully funding those already.

To get the most out of your savings, review your savings account interest rates at least as often as you review your W-4 withholding, around April and November. You want to make sure your savings accounts are earning the best interest rates, so that extra money you're putting away will do you the most good.

If your company uses direct deposit, set up an automatic direct deposit into your high-interest savings account or investment accounts. That way, just like when the money was being withheld by the government, you never need to feel the pinch of putting it aside for savings. It'll happen invisibly.

The difference is that instead of letting Uncle Sam collect the interest on your money, you'll be doing that yourself. You'll build your savings faster and have more control over where your money goes.

In April, instead of waiting for a check from the IRS, you can take a look at your savings balance and see your "tax refund" waiting for you, enhanced by the interest it's earned throughout the year.

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