Why Your Large Tax Refund May be Costing You Money
One of my closest friends jokes that he became a tax accountant so he could learn legal ways to “screw the government” out of money. He’s more than willing to pay his fair share of taxes to support the nation and programs he cares about, but not a penny more. And isn’t that really what we’re all after. We’ll pay our fair share, but at the end of the day we’re trying to get by too. We don’t want to leave any money on the table if it could be in our bank accounts instead. So why do we over-withhold from our paychecks?
Here’s where I confess that I am a notorious overwithholder (yeah… I’m going to make that a word now). The idea of the government telling me that I owe them money is not something I’m easily comforted by, but I’ve been making a conscious attempt to curve that over the past years, because really what I’m doing is lending the government money that I could be using for my own benefit.
Where It Hurts the Most
When you over-withhold taxes from your paycheck, the biggest cost is the money you could have been making via interest or other appreciation. Albert Einstein once called compound interest “the eighth wonder of the world,” and I certainly wouldn’t argue with Einstein. Essentially, the biggest issue is that you could have been investing that extra money you were giving to the IRS for your own saving purposes and accumulating interest or buying a house that would (hopefully) reward you with some appreciation in the future. The government, on the other hand, is paying you nothing to hold onto your money for the next year or so. At the very least they should write you a thank you note!
This may or may not add up for you. If you’re the kind of person that will religiously take the money you make above your expenses on a monthly basis and move those funds to savings or an investment, then this can really hurt you. If you struggle to do that on a monthly basis, but have no problem taking that lump sum refund and immediately investing it because it feels like “found money” to you, then maybe that’s what you need to get you motivated to save. Just know that the latter attitude will ultimately cost you on some level, so challenging yourself to invest more regularly is always preferable.
What You Can Do About It
With tax season upon us, you should be getting an idea of just how big your refund is. If you’re getting more than a couple hundred dollars back, it’s time to look at your withholding. Most larger corporations will allow you to update your IRS Form W-4 online through their HR portal. If your company is smaller, reach out to your HR contacts and tell them you want to update your W-4. They should be happy to oblige you. Remember, when you’re updating your W-4, the higher the total “allowances” (Line H) you report, the less money will be withheld from your paycheck. Therefore, if you’re over-withholding you will need to add another allowance. Look over the form and see if you’ve had any life changes that may be causing this disconnect. Feel free to reach out to your HR personnel or an accountant if you need help.
What If You End Up Owing Money?
Ideally, if you’ve fixed your withholding amount your refund will be as close to zero as possible, but it’s possible that you may owe the government money if you’ve under-withheld or have other income (i.e. interest and dividends) where you are not withholding for taxes. However, if you’ve really been using that extra money in your paychecks to fund your savings account this shouldn’t be a problem. Gauge your commitment to saving and understand if this is something you can commit to.
The Bottom Line
Though you may not have the fun adrenaline rush of seeing a large refund deposited into your bank account next year, you will be able to say that you made a wise decision to maximize your savings and build wealth.
Written By: Lindsay Dell Cook
Lindsay Dell Cook is an accountant, turned writer and founder of Budget Babble. She lives in Philadelphia with her uber supportive husband, and enjoys taking their adorable mutt for walks or reading a good book while buried under a pile of cats.