According to the IRS, the average tax refund received in 2015 was just about $2,800. Receiving such a large check from the government can be exciting but adjusting their withholding and receiving a smaller refund might actually be more beneficial for taxpayers.
A tax refund is the return of taxes paid beyond what was owed based on a person’s individual tax situation. So instead of thinking of it as a refund consider it more like change; imagine paying $150 a month for a cable bill that’s only $100 a month, then receiving a check from the cable company for $600 after the year is over. Sure, that $600 check is nice, but it’s $600 that you should have had throughout the year.
Of course, taxes aren’t that simple. Submitting a W4 to your employer can give you a very rough estimate of your tax liability, but these forms don’t take into consideration all the things that can negatively or positively impact your taxes such as investments, medical bills, salary changes, credits, and deductions.
Most people probably would rather overpay and receive a refund than risk underpaying and owe more taxes. As such, reducing your tax withholding might not seem like an attractive course of action. However, consider a situation in which a person receives a tax refund of $2,800. This person paid more than $230 a month in extra taxes. That’s money that could have been added to savings and investments. Yes, the tax refund could be invested or deposited into a savings account, but the money would have gained interest if it were instead deposited in smaller amounts throughout the year.
Similarly, using this tax refund to make a large, lump sum payment on debt is a great idea. However, taxpayers could save money on interest by increasing their net income per paycheck by decreasing their withholding and putting the extra money towards their monthly debt payment.
Here’s a a simple example. Let’s say that in January 2015, you had a $1,000 balance on a credit card with 18% interest and could only afford to pay $50 a month on that debt. Then, in March of 2016, you received a tax refund of $2,800 and used some of that to pay off the balance on the credit card. At that point, you would have paid $700 ($50 a month from January 2015 to February 2016), leaving $459.24 to be paid off with your tax refund in March. In the end, you would have paid a total of $1,159.24 to pay off the $1,000 credit debt plus 18% interest over 15 months.
That’s pretty good. However, if you paid $230 less in taxes every month, you could have made monthly payments of $280 and paid the balance off in four months for only $1,035.92 – over $100 less than in the previous scenario.
A large tax refund is nice, but adjusting your withholding and getting a smaller refund can actually mean more financial freedom throughout the year. That said, there might be practical or personal reasons not to do it. Lowering your refund might make you uncomfortable if you’re wary of owing taxes. Or perhaps you view tax refunds as a type of forced savings — money that you could have saved throughout the year but probably wouldn’t have.
Ultimately, whether or not lowering your tax refund is a good idea will depend on you. If you received a large tax refund and would like to know if adjusting your withholdings makes sense for your finances, contact your HR department and/or a tax professional to discuss your W4 and the options that might be best for you and your tax situation.
The information and data provided here are only examples and are for informative purposes only. It is not intended to be tax advice.