My husband and I get a tax refund every year and until recently we thought that was a good thing. You probably think it’s a good thing too. It feels good to get a check in the mail or see that sum suddenly appear in your bank account.
Most people tend to celebrate and have fun thinking about what they will do with their nice chunk of change. But a tax refund is actually a bad thing. Why? Because it means you paid too much to the government throughout the year and now they are paying you back interest free. That’s YOUR money they’ve been holding onto, using, making interest off of. You could have been taking home extra money each month and using it to pay down debt, build up your savings, buy more chocolate, whatever you consider a priority in your life. Instead you gave it to them to hold onto until tax time.
Think about how much more that refund would be worth right now if you’d been investing it throughout the year. Or think about how much less interest your debt would have accrued throughout the year if you had been able to pay more of it off each month. Are you starting to see why a tax refund is not something to be celebrated? Good! Now let’s talk about what you can do about it.
Avoiding tax refunds
How can you avoid a tax refund in the future? One way is to ask your employer to give you a new W-4 tax form to fill out. A W-4 tells your employer how much federal income tax to withhold from your paycheck. The more allowances you claim, the less taxes will be withheld. If you claim more allowances than the last time you filled out the form then less tax will be withheld. This means your take home pay will increase and your potential for a tax refund will decrease. You can claim as many dependents or allowances as you want on your W-4 regardless of whether or not you actually have any dependents. There is no law that prohibits you from doing this.
Calculate the amount you are overpaying
Here is your next step. Take the total refund you received this year and divide by however many pay periods you have in one year. If you are paid every other Friday, you will divide by 26. If you’re only paid once a month you will divide by 12. Once you’ve figured out your answer, that will be the amount per paycheck that you’ve been overpaying. You can then go to your employer and ask them to help you figure out how many allowances you need to claim in order to stop having that amount withheld from your paycheck. They will contact their payroll company to find out for you and will most likely not be able to get it exact, but as long as it’s within a few dollars it will do. The goal is to get it as close as possible.
A tax refund means you paid too much to the government throughout the year and now they are paying you back interest free. That’s YOUR money they’ve been holding onto, using, making interest off of. You could have been taking home extra money… Click To Tweet
Here’s an example with real numbers. Let’s say last year I got a tax refund of $3,900. I get paid every other week, so I’m going to divide $3,900 by 26 to get $150. $150 less in taxes need to be withheld from each paycheck in order to avoid getting a refund. I currently have $275 withheld from each paycheck and I now need to reduce it by $150. This comes out to $125. At this point I would go to my employer and ask them how many allowances I would need to claim on my W-4 in order to bring my withholdings down to $125 per paycheck. They will contact their payroll company to find out and I’ll make the necessary adjustments on my new W-4 form. I have now added over $300 per month to my take home pay and reduced my refund to almost nothing.
It’s not an exact science
Like I said, you will most likely not be able to get it exact. You might still end up with a very small refund at the end of the year, or you might end up owing a small amount. I personally would rather owe a small amount than be owed a large amount that I could have had in my possession all along.
Now that you know that tax refunds are bad and how to avoid them in the future, what will you do with your extra take home pay?
Disclaimer: This information is based on standard salaries and might not necessarily apply to commissions, bonuses, or any other type of pay structure. Please consult with your tax professional for more information.
