Tax Refunds - Good or Meh?

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Another tax deadline has come and gone.  Did you enjoy a nice big tax refund?  Free money, right?   Whoa … let’s hold that thought for a moment.

Before you look forward to another big refund next year, think about how you have “earned” that refund.  It might not be the free money you think it is.

How the refund process works

Remember that first day of work?  Paperwork like emergency contact forms, orientation materials, and company policies grew before your eyes.  You may have even felt like you were signing your life away.

One of the forms you had to fill out was a W-4.  In the W-4, you told your employer how you wanted your income taxes deducted from your paycheck.  Perhaps your first reaction was, “No thanks, I’ll pass on participating in the income tax program.”  When that didn’t work, you completed a pretty simple form.  You checked a box if you’re married and filled in your number of dependents.  That information gave your payroll office an idea of your tax rate.

Every paycheck, your employer takes a percentage of your gross pay and sends it to the IRS. That’s called your “withholding.” If you’re withholding the right amount, the IRS should get as much money as it’s due for your annual income taxes.  

The problem is...

the withholding formula is designed to protect people from having to cough up money in April.  For millions of Americans who live paycheck to paycheck, this would be a significant hardship. So, the withholding formula errs on the side of over-withholding.

When you complete your tax return, you’ll be much more aggressive in figuring your deductions and credits.  You’ll also wind up with an income that’s a little lower than what your employer was estimating.  That means you get a refund.  The government pays back some of the money it withheld from your paycheck.  That’s good, right?  Maybe not.

When you have more taxes withheld from your pay than you end up owing, you have given the government an interest-free loan.  From this perspective, your refund represents a loss.  If that amount had been sitting in a savings account earning interest, you’d have more money in the end!

 

Why is your salary different on your tax return?

There are several reasons why your tax bill may be different than your employer was estimating.  If you qualify for tax credits like the Earned Income Tax Credit or the Child and Dependent Care Credit, those numbers aren’t reflected in your paycheck.  It’s the same with tax deductions you may have like mortgage interest, property taxes, and charitable contributions. 

Trying to estimate the tax credits and deductions you will have at the end of the year can be difficult, especially if your income changes over the course of the year.  It’s hard to take these factors into consideration when determining how much to have withheld from your pay.

You might also have received a promotion or a raise this year. The withholding rate assumes you’ve been making that same salary all year, so a bump in salary means a bump in withholding.  Changes in income are also difficult to plan for, and adjusting your W-4 mid-year, only to change it back the next April, probably isn’t worth it.

If this was just a regular year with no significant changes in income, dependents, or deductions and you’re getting $2,000-3,000 back, you’re just over-withholding. To figure out how much you’re over-withholding, take your refund and divide it by the number of paychecks you get in a year (26 if you’re paid bi-weekly, 12 if you’re paid monthly).

The mean American tax refund is approximately $2,800, which means the average person is over-withholding by $233 each month!

What to do instead

You can fill out a new W-4 at any time. The IRS has a W-4 Calculator to view different scenarios and help you determine if you are withholding the right amount.  You will want to have your last pay stub at hand when you use the calculator.

It’s unlikely you’ll nail your tax burden precisely, and it’s better to overestimate than underestimate your tax payments.  Still, fixing your withholding could result in another $200 in your pocket every month!  If that $200 would just slip through your fingers, you may be better off letting the IRS hold on to it for you.  However, if you have a plan for that money, and stick to it, the hassle of the paperwork may be worthwhile.

 

Here are a few ways to put that money to work.

1. Use it to pay down your high-interest debt. If you have some credit card balances at rates near 20%, paying it off is like getting a no-risk 20% return on investment. Beating that is tough! The same is true of student loan debt or other obligations. 

2. Start an emergency fund. The root of most debt is an unexpected expense on a tight budget. Being able to use cash to cover car repairs, medical expenses or an unexpected short paycheck can keep money off the credit card and in your pocket. 

3. Put it in a retirement fund. Increase your contribution to your 401(k) program or IRA. You can reduce your tax burden even further and raise your quality of life down the road.

4. Use the extra budget space to start a money-making side project. With a few power tools, a bucket of paint and imagination, you could turn curbside furniture into treasures!

Whatever you choose, you don’t have to wait for tax time to get access to those funds.  It’s your money, and now it’s working for you.

 

SOURCES:
https://apps.irs.gov/app/withholdingcalculator/
https://www.irs.gov/Credits-&-Deductions/Individuals/Child-and-Dependent-Care-Credit
http://www.learnvest.com/knowledge-center/got-a-tax-refund-3-big-reasons-you-dont-want-one/http://www.marketwatch.com/story/10-reasons-to-reduce-your-tax-refund-2015-04-01

Securities and Advisory services offered through Cetera Advisor Networks, Member FINRA, SIPC. Cetera Advisor Networks is not an affiliate of Genisys Credit Union.  Mutual funds, annuities and other investments available through Cetera Advisor Networks are not insured by the FDIC, NCUSIF or any federal government agency, are not deposits, or obligations of nor guaranteed by Genisys Credit Union, or any other affiliated entity. Investments are subject to investment risks including loss of principal invested.

 

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