Karen Brady, CFP®, takes apart a topic that mystifies many a Grownup: annual taxes.
Getting a big hunk of cash deposited to your checking account each spring feels good. Scratch that—it feels amazing. Despite the major feels that a big tax refund can give, it may also bring up a nagging question, though: “Am I doing this right?"
Let's start from the beginning. What exactly is a tax refund and how does it work?
When you start your new job, the HR department or your manager will likely hand you a form, called a W-4, or tell you to fill one out online. The number of allowances you claim on this form controls how much will be withheld from each of your paychecks to pay taxes down the line. This number will be determined by your personal situation (think tax filing status, how many dependents you have, and so on). The higher the allowances, the less money is withheld and vice versa.
Ideally, the amount that is withheld throughout the year would be the same as your tax bill come April 15. However, this is rarely the case. Just like life, the tax code can be messy. So if you are receiving a tax refund, the amount that was withheld was more than the amount you actually owed. Rather than thinking of this as a nice little gift from the IRS, consider your refund as a return of cash to its rightful owner—you.
There are some pros that come along with a big tax refund:
- Extra taxes withheld throughout the year force you to save (without you even realizing it)
If you are currently contributing to a retirement plan at work, let me ask you a question. Do you even really notice? Do you see your check every two weeks and think, “I really wish I had that $75 in my pocket instead"? My guess would be no.
Since those retirement contributions come directly out of our paychecks without us doing any work, most of us barely notice them at all, unless you take the time to sit down and review your pay stub regularly. (But let's be honest here, how often are you really doing that?)
Your tax withholding operates in the same way. A portion of your paycheck is withheld to cover your tax bill come April 15, and you're probably not paying too much attention. Essentially, the tax man is doing the work of saving on your behalf and holding those funds for safekeeping. This can be a major plus if you struggle with saving in the first place, or can't seem to stop tapping your savings account when there is cash available.
- You can use your refund to get you closer to achieving your financial goals—whatever they may be
Now that you've had a little help saving throughout the year, you can use the extra cash from your refund to pay extra towards student loans or other debt, contribute to an IRA for the current year, or use it for any other financial goal you may have. Sometimes, paying little by little each month can feel really daunting. But having a lump sum—like your tax refund—to put towards a debt or savings goal can be incredibly motivating. You'll likely be able to see your progress and benefit from some instant gratification. Slow and steady wins the race, but it can also be nice to feel the impact of a quick sprint.
On the flip side, there are some cons to consider when receiving a big tax refund:
- You don't get anything in return for extra withholding
Withholding a little bit extra with each paycheck is the equivalent of making a deposit to a savings account at the Bank of IRS. There's one big catch, though: This savings account pays zero interest. Sure, you may not be raking in the interest income at your bank, but it's better than nothing.
- You don't have access to your cash throughout the year
When you deposit your extra cash into a savings account on regular basis, you always have the choice to withdraw the funds. It's yours, after all. This can really come in handy in case of an emergency or some unexpected expense. However, your extra tax withholding cannot be “withdrawn" or returned to you before you file your taxes and receive your refund. You've stashed your extra cash with the IRS and now you're on their timeline, no matter what comes up.
There's no right or wrong answer when it comes to getting a tax refund. Consider the pros and cons and determine what is right for you: a big tax refund or a little extra in each paycheck. If your withholdings are off, adjust the number of allowances on your W-4 and be on your merry way.
Grownups, do you prefer to receive a large refund at tax time, or a little more in your paycheck throughout the year? Share your thoughts by leaving a comment!