Friday, January 21, 2011

Excited about your big income tax refund?

Maybe you shouldn’t be.

Often I hear folks all excited and giddy about the big income tax refund they just received. But is this really a good thing to get all that happy about?

The income tax refund is simply that—a refund. A refund of your own money. It means that more money was withheld from your paycheck than was necessary for your income tax obligation. Many people use this as a forced savings plan. That way, they feel that they will have a larger lump sum of money at the beginning of the year to use for a large purchase or to pay down debt. If they got the same amount within their regular paycheck, they might never have a savings account. They would likely spend it unwisely or it might just slip between their fingers and disappear.

There are several reasons, however, why the big refund may not be the best choice.

First, you have a smaller regular paycheck. There may be times through the year when you need these funds, but, until you receive your refund, you have no access to them.

Next, you’ve made an interest-free loan to the IRS. When it’s in your own savings account, at least you will receive interest on it. In your IRS savings account, you get no interest. As pitiful as savings account interest rates are these days, at least you got something.

If you think that it’s a good idea to use your refund to pay down debt once a year, think again. What about all that interest that was accumulating on that debt? That credit card balance of $4000, at an 18 percent interest rate, that you paid off with your income tax refund could be costing you $720 in interest charges. Surely, you could find a better use for that $720.

The large refund can be an indication of poor or non-existent financial planning. You have no access to those funds over the course of the year to use for emergencies or other immediate needs. If you are unable to resist spending the additional money in your paycheck, consider having an amount automatically transferred from your checking into a savings account. Out of sight and out of mind. You have your savings account and you still have access to it, if necessary, and you got at least some interest on those funds.

The large refund can be an indication of poor or non-existent tax planning IRS Form W-4 Personal Allowances Worksheet can be used to adjust withholding from your paycheck. Those who are self-employed can make estimated quarterly payments based on what should have been paid last year. The worksheet for Form W-4 and instructions for estimated taxes can be found at

But you may not want to end up owing income taxes. What if you have other sources of income such as interest, dividends, or other non-wage income on which income taxes have not been withheld? If you don’t want to have a payment due, you can back off on the number of personal allowances claimed on the Form W-4.

You are not paying any less in income taxes by having more withheld from your paycheck. Whether you opt for the bigger paycheck or the bigger refund, your total tax obligation remains the same. You can get the money in your regular paycheck or wait and get it later. The choice is yours. Which would you rather do?

No comments: