Tax season is something that comes around the same time every year. Yet, it still creeps up on us and leaves us wondering if we’ll be getting a refund or break even.
Considering the simplicity of my taxes, I almost always received a refund of some amount, and admit that it’s something I look forward to in the bleak mid-winter months.
Receiving a sizeable refund also makes it easier to put a bigger dent in your debt, start an online savings account or retirement account, or place a down payment on a house. But, other than the perk of getting a chunk of money at the end of the year, is getting a large tax refund a smart choice, financially?
Let’s take a look at the facts.
Interest-free loan to the government
Did you realise that when you’ve overpaid your taxes all year, and receive a large refund, that you’ve literally been lending the government money interest-free?
This might not bother you at first, but if you think about it, there are probably much better ways to spend that money if you had access to it all year. Instead of overpaying your taxes, had been placed in a savings account it would have earned you money in interest!
Take a look at how much money you received for your last tax refund, and divide it by twelve months. Then calculate the average interest rate your savings or investment account would have paid, and how much more money you could have had at the end of the year.
If nothing else, that should bother you. One financial expert estimates that if you receive a $3,000 refund, it represents about $250 a month you could have used in your budget.
Forced savings method
You may have a hard time setting aside money from each paycheque for savings, so a large lump-sum payment in the form of a tax refund is a good way to save without having to think about it (a method of forced savings, if you will). This could be a smart idea, but the problem with this view is that you’ll be waiting the entire year to also utilise that savings or invest it. You’re missing out on interest payments, and other ways to leverage your income to work for you.
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Afraid of underpayment
In spite of the financial logic of only paying the government what you owe, you may be concerned about owing taxes at the end of the year, so you’d rather cling to the security of knowing you’re overpaying instead of underpaying.
Owing the government a little bit of money for taxes isn’t a big deal if you’re prepared, but calculating your taxes so you break even is ultimately the best option. Having the mindset of underpayment security by deliberately paying too much is throwing a large bill at the drive-through attendant instead of finding out what you owe.
Take the time to calculate your taxes, and find out if you need to save more, or if you’re on track.
Tools to calculate your taxes
First of all, the IRS has a tool on their site that can help you calculate what you’ll owe in taxes all year and how much you should have withheld each paycheck. This is especially helpful if you’re self-employed or an independent contractor who will be paying your own taxes and don’t want to get stuck with the bill all at once.
If you’ve done well at estimating your withholding in the past, be aware that any major life changes, such as status, having children, buying a house, or opening a business, can drastically impact your tax bill.
The personnel director at your job should also have insight into general tax withholding tips, or who to contact for further advice.
Receiving a tax refund may be a hard habit to break. After all, who doesn’t want to receive a surprise lump sum of money? But it may make more sense for you to owe the IRS a small amount, than to overpay throughout the year.
In spite of habit, understanding the financial implications can help you realize that receiving a large refund might not be the best decision, and change your mentality towards tax refunds forever.
