When you file your taxes, do you expect a big refund check? Are you anticipating finally paying off some of those bills with the accrued money the government owes you? If you typically let the government sit on your money for the whole year — often longer than a year depending on when you file your taxes — you’re giving them an interest-free loan.
Relying on a big refund check isn’t the worst financial decision you could make, but it is the laziest decision. You could be using that money each month to improve your financial situation rather than waiting until your refund arrives.
There are a few key reasons why we don’t like giving the government our money as an interest-free loan.
Yes, you do eventually get the refund back, but your financial situation would be better off if you received it throughout the year. Let’s say you get a $3,600 refund. That’s $300 per month. You could take that extra money each month and do a number of things, e.g.,
You might do those things once the refund comes in, but in the mean time you’ve paid interest on those debts and received no interest in return from the government.
A major problem many people have with a big tax refund is they don’t know how to handle it. It’s nice to get a $3,600 check, but it only really does you good if you put it toward those debts and financial goals you’ve set up. Many people that receive a lump sum of cash (either through an estate, through the lottery, or as a tax refund) don’t control that amount of money well. Maybe some of it goes towards those goals, but suddenly a new TV shows up in the living room. It is easy to overspend a big refund check.
There are some people that willingly decide to just get a tax refund and not adjust their withholdings. They know they could be doing better with their finances, but take the lazy route. This shows a lack of control in the area of finances and leads to paying unnecessary amounts of interest.
However, there are two instances when it is okay to rely on a big tax refund.
If you adjust your withholdings so you get more cash in each of your paychecks throughout the year you do run the slight risk of not paying enough tax to the government. In that case when you file your taxes you suddenly find yourself owing money to the government rather than them owing you. If you are in a poor financial situation you might not have the extra cash to pay the tax back. In this case leaving everything at status quo might be the better decision until your situation improves.
Getting extra money each paycheck throughout the year is better than a lump sum in the spring of the following year. That is unless you know yourself well and know you will end up wasting all of that extra money and have nothing to show for it. In this case waiting for a tax refund — and then wisely using that refund — is the best choice for you.
There are two critical steps you must take if you want to stop giving the government a interest-free loan while still not wasting the money yourself.
The first step is easy: simply change your withholdings with the federal government through Form W-4. If you typically get a refund from your state you will want to adjust your state’s withholding as well. You can try making small changes are first: if you currently have 5 allowances calculated into your withholding, don’t drop to 0. You can switch to 3 or 4 and see what kind of a difference it makes in your check. Use small steps rather than giant leaps to find the “just right” amount of withholding that leaves you with no tax owed and no huge tax refund.
If you change your withholding allowances and waste the extra money each month, you’ve actually taken a step backwards. To avoid making this big mistake, you need to set up a system to automatically use that extra cash you get in each check.
Here’s a simple formula of how to do this:
Here’s an example based on the system above:
As you can see, setting up a system to automatically handle the extra income is key to avoid it being spent through the regular ups and downs of life. If you let that happen you won’t get a big tax refund, and you won’t improve your situation throughout the year. Be diligent, use a system, and maximize that extra tax you pay every month.
Photo from Wikimedia Commons.
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