While it feels nice to get a big tax refund every year, there’s a danger of thinking of it as a bonus or reward for filing your taxes. Ideally, however, you want to be as close to zero as possible, as there are better uses for your money other than giving the IRS an interest-free loan every year.
Why you don’t want big refunds
If you have fluctuating income and expenses, it can be difficult to know how much money to withhold for taxes every year. For this reason, it makes sense that so many people choose to play it safe by overestimating their taxes, as it’s better than dealing with an unexpected shortfall at tax time. Still, that’s a lot of money tied up all year—$2,869, on average for 2019, according to the IRS.
There isn’t anything necessarily wrong with using your tax refund as a de facto savings account —especially since the interest rates on savings accounts are nearly zero percent—but there are simply better ways to use that money, especially if you have debt.
Use the money on an emergency fund, debt or savings
Let’s say you’re pretty much like everyone else, and carry some credit card debt—say, $6,270, which is the average for U.S. families, according to the most recent data. If you receive a refund totaling $3,000, all that means is that you missed out on $250 monthly payments that would have nearly halved your total credit card debt. And if your card has 16% APR, you would have whittled down your monthly interest payments from roughly $80 to $40, which of course, is money spent merely servicing the debt, not the principal.
Likewise, if you don’t have an emergency fund that covers three-six months of your expenses, you’ll want that cash handy. Having it tied up by the IRS doesn’t give you the same flexibility as putting the money aside in an easily accessible bank account each month.
Another suggestion would be to plow those funds into retirement savings, especially if you have high-interest debt under control. This is actually a golden opportunity to start saving more—psychologically speaking, you’re already not used to seeing that amount as part of your monthly budget. You’ll still have to keep an eye on your spending, of course (i.e., you won’t be bailed out by the yearly tax refund), but it’s a good way to transition into getting serious about your 401(k) or IRA fund.
How to stay on top of your tax withholding
Try using the IRS’ Paycheck Checkup tool at least twice a year, which will help you fine-tune your tax withholding so that your refund is closer to zero dollars (this step-by-step tutorial video will walk you through the steps).
Another way to do this is to manually check your paystub and see how much your employer withheld for your federal income tax, and then project how much you expect to owe over the full year (if you get paid twice a month, you would multiply the withholding amount by 24).
If you discover your current withholdings need to be adjusted, you can complete a new Form W-4—aka your Employee’s Withholding Certificate—and submit it to your employer. After you do, keep an eye on your next few paychecks to make sure the change has been applied properly.
Unfortunately, freelancers have to deal with a more complicated situation that requires quarterly monitoring, but you can at least use last year’s tax liability as a benchmark, if your workload is stable.