What's Wrong with a Tax Refund?
March 31, 2016
Getting a big tax refund this year? But is getting a bigger refund always better?
Are you getting a big tax refund this year? Many people I meet get super excited about how big their tax refund is going to be. It feels great, but if you could get more money throughout the year on each paycheck imagine what could be accomplished.
Let’s explore what is actually happening for many people. Each year employees fill out a W-4 to tell their employer how much to withhold from their wages for taxes. Many people think they have to pick the withholdings that are true to their situation; for example if you are married with two children you might assume you need to pick Married – 2. The numbers you pick here are totally up to you. You have the choice to withhold too much and leave your hard earned money with the government all year, or you can pay too little and risk paying penalties to the IRS.
Dialing in your withholdings should be something that you make sure is handled, particularly when the IRS has recent funding issues than can make tax returns take longer than expected. However, trying to figure out the right withholdings can be daunting. If you have a good relationship with a CPA, they should be able to help you determine how different withholdings will affect your refund. If you do not, the IRS has a handy Withholdings Calculator you can use to help you figure it out.
I argue that most people should target a break even on their tax withholdings, erring on the side of a small refund. Why give the government more than you have to if you could instead keep your money throughout the year and do something with those dollars. There are so many positive things that could be done with more money each month, particularly when compound interest is on your side. One of my favorite quotes comes from Albert Einstein, “Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t… pays it.”
One simple way to put additional dollars to work each paycheck is to increase your 401(k) contribution. Much of the population is behind on retirement savings and the 401(k) is often one of the easiest and most effective ways to save for retirement. Some companies can also set up a separate payroll contribution to a savings account aside from your checking account to help you save. Or you could set up a monthly transfer from checking to savings on the day after you get paid so you aren’t tempted to spend the additional money you get each month. If you are working with a financial advisor then you should have a budget and your monthly cash flow should be put to work as part of your financial plan. It is easy to adjust a financial plan to accommodate more monthly income, and the results in the long run with compound interest can be amazing.
**NPC does not provide tax nor legal advice.