How A Big Tax Refund Is Actually Costing You Money
Tax season is here and it’s time for everyone to enjoy their tax refunds, maybe. 2018 was the first year of the major tax system overhaul put in place by Donald Trump. Some people think that this new system is rigged in favor of the rich while others think it helped the average American. I’m not here to debate that, rather show you how and why your tax refund may be smaller this year and why that’s a good thing.
A big tax refund is actually costing you money because it is essentially the government just returning your money to you. I mean, it’s called a refund for a reason, right? What you’ve done is paid more than your fair share throughout the year when taxes are taken out of your paycheck. Unfortunately, we have been trained as a society to view it as a bonus rather than getting back what’s rightfully yours.
When I was young I remember the first time I got a tax refund. I believe I was 16 at the time and it came out to be a whopping $250, or something close to that. I was a teenager and my only income came from being a farm hand so it wasn’t much. It did, however, feel like Christmas. How cool is it that I pay my taxes and then a couple weeks later, I all of a sudden get a deposit from the government into my checking account? I thought to myself, I love taxes, let me pay more taxes.
What I didn’t realize at the time was that big yearly bonus was just the government returning my money. I wasn’t actually getting paid for being a good citizen.
How Your Tax Refund Works
Your tax refund is not a bonus; it is your money. Your hard-earne money that has been sitting in a government bank that you can’t touch and only they can spend.
Seems backward right? Well in the world we live in, the government gets paid first, no matter what. If you’ve ever received a pay stub, you’ve seen the breakdown of how your check is divided up. Your pay stub will show your gross pay minus a whole bunch of different types of taxes and then finally at the bottom your take-home pay. Take-home is what you see in your checking account, the number you and I really care about.
What we often overlook is all those expenses that are taken out of our gross pay. If you didn’t know, you can control how much is taken out each month through your W4 choices. But we’ll talk about those later in the article.
Your refund comes directly from those taxes taken out of each paycheck. Slowly but surely throughout the year, they add up into a pretty sizeable amount. Finally at the end of the year when you file your taxes, the government compares how much you should have paid to what you actually did through your paychecks. That number is based on your annual income and the tax bracket that you fall under.
If you paid in too much throughout the year, you get a refund. Pay too little and you owe.
Side note: In some states, an employer doesn’t have to give you a pay stub with every check. However, if you do request your records they legally have to supply it to you. If you’re curious then just ask your employer.
So Why Do You Want It Lower?
To put it in the most basic context possible, when you overpay on your taxes and get a huge refund all you’ve been doing is giving the government a zero interest loan for that year. I’ll show you the math in a little bit but you’re wasting the time that your money could be compounding. Multiply this over many years and it’s nothing to laugh about.
I should mention that if your refund is under $250 per year, then you are doing fine. $250 isn’t what I would consider a large amount and I wouldn’t adjust anything. There are people that have had refunds over $5,000+, and that’s a problem. As a good rule of thumb, if your refund is over $1,000 in 2 consecutive years, then you need to adjust your W4. I don’t want to give the government a cent more than I have to, let alone thousands of dollars.
Instead of lending that money to the government for a year and receiving $0 in interest payments you could be putting it to use in other areas of your life.
Have student loans? Well, an extra couple hundred bucks a month could help pay those down.
Don’t have an emergency fund? Problem solved, take that extra money and put it right into a savings account.
Think you don’t have the cash to save for retirement? Well, that excuse won’t work anymore. Be ready to kick your investing into overdrive.
All of this can be summarized in this tweet:
Why You May Want A Large Refund
This whole article has been about how lowering your tax refund will help you in the long run. Is there a time where you should maximize your refund? Well, kind of. Since you’re reading my blog I’m going to assume you want to become more intelligent financially. Unfortunately, though, we are humans and we make a lot of poor decisions. Especially when it comes to money.
We’ve all heard the statistics about how most Americans don’t have $1,000 in their checking. How more and more people aren’t paying on their loans. The list goes on and on but the bottom line is we are terrible with money.
This may be a good reason for you to actually maximize your tax refund. I know this sounds crazy but if your monthly paycheck all of a sudden is a significantly larger amount, are you going to just spend it all? This is a question you need to ask yourself. Can you delay that instant satisfaction of the newest technology or hottest pair of shoes? Would you be able to take that extra money every month and put it to good use?
If you can’t exhibit self-control then maybe it is a good idea to wait till you get your refund. Once that big check hits, it doesn’t give you the freedom to just go blow it all. Instead, for that one time every year you need to make a conscious decision to put some of that into a savings account, investment account, or debt repayment. Again, I don’t recommend doing this since it’s still going to cost you big in the long run. But a small nest egg is better than no nest egg.
How Do I Adjust My Refund?
You’ve decided you’re tired of loaning the government money and you are ready to get your money back. What do you do? The first and potentially only thing you need to do is adjust your W4. A W4 is something you fill out when you are first employed by a company. This document tells your employer how much tax they need to be taking out of each of your paychecks. Essentially they are acting like the IRS. You’re going to pay taxes one way or the other. By taking it out of your paycheck now, the IRS is ensuring they get their money.
What most of you are probably familiar with is a W2. In fact, as of this publishing (February), you’ve probably received one in the last couple of weeks. A W2 is just the summary of what your employer paid to each different tax segment over that year. Some examples are federal income, social security, Medicare, and so on. If you want to learn how to properly fill out your W4 or adjust your current one then check out Nerd Wallet’s article.
Some of you may have different forms of income besides just a W2 job. This is great and I applaud you. To figure out what else you can do to get your refund down, you should consult your CPA.
Let’s Do The Math
This seems simple enough, right? What I think will really drive this point home is putting the math to it. Without collecting everyone’s tax information, this example is going to seem oversimplified but it will suffice for this article. If you feel like it, plug in your own numbers.
What I want to look at next are two scenarios. Imagine you adjusted your W4 and had to pay $0 in taxes at the end of the year vs. leaving your W4 and getting a $3,000 refund. If we took that refund and broke it down into monthly additions to your paycheck, you’d be taking home an extra $250 per month. Yes, I understand some people get paid weekly or bi-weekly but breaking it down even farther only further adds to the argument that you want a lower refund since it gives your money more time to compound. Anyway, what would happen if you took that $250 and put it into a Roth IRA that made 10% annually? How much would that be worth to you? Here’s the math:
By simply adjusting your W4, you could have an extra $141 per year. It’s only $141 though so is that really worth all the trouble? Well, when this happens year after year for forty plus years, it sure is worth it. That $141 per year quickly adds up to thousands of dollars that could have been yours as a result of compounding interest.
To prove this, let’s stretch out the math over those forty years. For this example let’s say you get the same refund every year and you put half of it away each year into your Roth IRA. I get that this is rare since most people blow their refund before they even get it but you’re different. Also, this is oversimplified. For some, it actually may be a whole lot more than this. We’re not taking into account inflation, income adjustments, or any of that. I went ahead and condensed the chart because no one wants to see forty years of data. Here’s how it would look:
Would you like to have an extra $34,000 in your retirement fund? Yes, it doesn’t seem like a big deal at the beginning but it adds up and adds up big. This example can get even scarier when you think about putting that extra cash to pay down something like credit card debt which can often have an interest rate over 20%. That $34k quickly can become over $100k.
The Bottom Line
To be honest, I knew that I didn’t want a big refund. There’s just something about that rush of seeing an influx of cash every year into your checking account that makes you want more of it. I’m not saying you should feel guilty about getting a refund. Rather, I want you to think about what that really means. If you didn’t know this, don’t feel bad. You are a part of the majority that has been convinced that the word refund is synonymous with a bonus.
It is important to understand that you need to look at your finances and taxes specifically from a macro-level. Looking at just a tax refund and not how much more you took home throughout the year paints a skewed view and leads people to form opinions like this:
This is absolutely false. The math doesn’t lie. If you can do what most can’t and delay that satisfaction then you’ll save yourself tens of thousands of dollars. Be responsible and take the
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