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A tax refund is essentially repayment of an interest-free loan you gave to the government. It results from withholding more for taxes in each paycheck throughout the year than your tax liability at the time you file. It may feel nice to receive a refund, but there are some downsides.
Receiving a tax refund in April, may seem like a pleasant, springtime pick-me-up, but tax refunds aren’t gifts. The money you get back has been yours all along. You had money withheld from your paychecks that could’ve been in your paycheck and available for you to use throughout the year. Think of it this way: If you had saved or invested that income, you could have earned interest on it, leaving you with more money in the long run.
A common impulse when receiving money on top of your steady income—like a tax refund—is to spend it. When that money is part of your regular paychecks, it may be easier to save and when you build a habit of saving, your balance can earn interest, which you don’t receive from the IRS.
Rather than spending your refund all at once, consider taking these steps.
Remember, even if you’re expecting a refund, you shouldn’t plan major purchases around receiving your check. With tax law changes and the actions of the IRS, it’s possible your refund will be smaller than anticipated or delayed.
If you do rely on the money you get back at tax time, you might be better off having access to those funds throughout the year. If you’re using the money to make a large purchase, you could consider saving and earning interest instead. If you’re using the money to pay down debt, the extra each month may help prevent the accumulation of more debt in the meantime.
Honestly, no one likes to pay more in taxes than they’ve already withheld throughout the year, but, owing a little bit more when you file your taxes may be more beneficial than it seems. Here’s why:
Increase in cash flow
Owing taxes when you file means that you under withheld from your income throughout the year, resulting in higher take-home pay in your paychecks. This can be a good thing, provided you don’t end up owing too much or incur an underpayment penalty.1
Potential saving and investing earnings
As we mentioned earlier, over withholding can result in an interest-free loan to the government, which doesn’t benefit you. Why not adjust your withholding and invest? Consider putting the extra money you receive in your paycheck into an interest-accruing or investment account so there may be opportunity for your balance to grow and accumulate wealth. A convenient option may be to boost your retirement savings by increasing your 401(k) contributions.
Flexibility of access to your funds
If you have that extra cash flow each month, you can choose to use it now, later or whenever you need it. The average federal tax refund for 2019 was roughly around $3,000 as of March 2020.2 That’s $250 a month Americans loaned interest-free to the government. That’s $250 per month that could help you meet your goals.
There are two sides to every story. Of course, there can be advantages to receiving a tax refund and disadvantages to owing taxes. What’s best for you depends on your personal financial situation. With proper planning, you can make smart choices for your withholding and put your income to good use. If you have access to Ayco as a benefit through your employer, speak with a coach to explore your options.
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For disclosures relating to this article, please click here.
Updated for tax year 2020