It’s that time of year again! Tax refund time! Depending on where you live, a tax refund may be a little bit of warmth in an otherwise cold season.
Most people that I personally know file their taxes as soon as they can after receiving their income statements from their employers. They are extremely excited to receive their refunds!
I used to be that way, waiting until February or March to see how much I was going to get back. It’s an exciting feeling.
The IRS reported in February 2016 that the average refund was $3,120 for the 2015 filing year. It’s exciting thinking about all of the possible things you could do with that money. For most of us, that’s more than a paycheck (or three!).
However, I’m not so sure that being so enthusiastic about a tax refund is in your best interest. In fact, I know it isn’t.
I mean, I get it.
Being given a lot of money once a year is a lot of fun. The only problem is that you aren’t being given anything. You are being given back what is yours in the first place.
What could you do with all of that money split up between your paychecks?
Here are some reasons why a tax refund isn’t really something to get excited about.
1) A Matter of Interest (Rates)
Do you get bummed out by the rate of return on a standard savings account? The average rate for a savings account these days is .01%. That is one-hundredth of a percent. It would take 100 of those to equal 1%. In short, it’s not a very good return. At. All.
Do you know what the interest rate is on your tax return being held by the IRS?
Ok. You get the picture. “Investing” with the IRS provides the only rate of return lower than a bank account outside of “Your Mattress” Bank.
You are literally earning nothing on the money that you’ve overpaid in taxes. And if you factor in the cost of the money you could have earned in interest by investing—the opportunity cost—your earnings are actually a negative number. Stinks, doesn’t it?
It’s literally an interest-free loan to the government.
2) What Happens When You Overpay?
Overpaying on anything is kind of an inconvenience. If you go to the store and they charge you too much, what do you do? Some people will fight tooth and nail for the money they are owed. Most people will say something in a nice way and get their money back. Very few won’t care at all.
The point? We all want our money back.
And we get it back as quickly as possible. We don’t wait until the first part of the year to get our money back.
So why do we take the opposite approach with the government?
We actually get excited about the government giving us our money back next year that we’re giving them now. There is no rhyme or reason for it. It’s the one area where we overpay and don’t care about getting our money back right away.
3) Your Debt vs. Their Debt
If you’re like most Americans, you have some debt that you need to pay off. The average credit card debt for balance carrying American households in 2016 (as of the 3rd quarter) was $16,061 according to NerdWallet .
They get their figures straight from the quarterly updates the Federal Reserve puts out.
You may have more debt than that. You may have less than that. Do you know how much debt the United States Government has?
Almost $20 Trillion! Let’s put that in actual numbers for you.
That is the exact current amount of U.S National Debt according to TreasuryDirect.
Our federal debt has skyrocketed over the past 10 years. In 2006, the federal debt was just over 8.5 Trillion. So we’ve more than doubled that in 10 years.
Between you and the government, who do you think is better at managing money? You are! 🙂 The U.S. Government has added some great services that we need to spend money on, but we have not found a way to pay for them.
The bottom line is that it is better to leave your money in your hands than the governments. I guarantee that you are better at managing your money than they are.
Quick note: This is not to say that paying taxes is bad. I definitely believe that everyone should pay their fair share of taxes to help with legitimate needs for the country. This is about overpayment. Paying in taxes what you actually don’t owe in taxes.
4) How Much Can This Save You?
Imagine this for a minute.
Say you have a credit card that has a $3,120 balance, the exact amount of the average income tax refund. You bought something at the beginning of 2016 and are waiting for your tax return to pay it off. You’ve been paying the minimum of $63 (about 2% of the balance) each month since January 2016. The interest rate on this card is 12%, an average interest rate.
If you are paying that minimum for 13 months, and pay the balance off in February when you receive your tax return, you will have paid $379.87 in interest.
Now, say you weren’t giving the IRS an interest-free loan. Dividing that amount by 12 would give you an extra $260 a month. And keep in mind that would be tax-free because you’ve already paid your taxes on the rest of your money. This is just an overpayment.
Having the same balance and interest rate, but this time using your $260 a month as a payment, you would have the card paid off in 13 months and pay $220.43 in interest.
By not giving the IRS free money, you’d be saving yourself $159.44 in interest. Not bad for only having to make a simple adjustment!
Keep in mind too this would still give you more net income per month than just the $260 because you wouldn’t be paying a $63 minimum payment on top of giving the IRS an extra $260 a month.
Note: Calculations were made using a credit card interest calculator from the always helpful bankrate.com.
Put This Into Action
The best way to not give the IRS an interest-free loan is to change the number of allowances on your check with your employer.
So for instance, instead of claiming 0 you could change that to 2 instead.
Unfortunately, it isn’t entirely that simple. You will need to figure out exactly what adding those allowance will do to your paycheck using a paycheck calculator.
For that, I recommend paycheckcity.com.
PaycheckCity is a fairly straightforward online calculator that you can use to figure out what your paycheck is going to be. You can put all of your information such as deductions and allowances into the calculator and it will spit out what your check is going to be based on the info you entered.
So if you received a refund last year of the average of $3,120, you’ll want to divide that by 26 if you are getting paid bi-weekly. If you get paid twice a month, simply divide that number by 24 instead.
Changing Your Deductions
After determining that you can safely gain $130 on your twice a month check, you’ll want to put your allowances in incrementally. If you usually claim 0, try claiming 1 and see where that gets you. If claiming 1 doesn’t get you around $130 extra on your check (which it probably won’t), then up your allowance to 2 and see what that does. Keep going until you hit around—but not over—$130, if you are getting paid 24 times a year. The calculations will be different if you are getting paid 26 times a year.
After you’re done calculating that, you’ll need to fill out a new W-4 form with your employer so they can change the amount of tax money being withheld from your paycheck. After that, you have just “given yourself a raise!”
If you are getting a refund from your state’s government as well, I recommend doing the same calculations for that so you are not overpaying in taxes.
So why go through the trouble of this at all?
Well, $3,120 is a lot of money! You could do any number of things with that money. It’s highly recommended that you do not give extra money to the IRS, even if your return isn’t usually that much.
Think about what even an extra $200 each month would do for you? Here are some things that you could do with that extra money:
- Pay off your debt faster
- Take a family vacation
- Build up your emergency fund
- Give yourself a little breathing room
- Allow you to go out to eat a little more
- Give more to your church or charitable organization
- Start a side hustle
- Invest in a 401K or Roth IRA
- Work on paying off your mortgage faster
There are a ton of things that you can do with the extra money you are giving the IRS. That means there are a ton of WHY’s to actually do the work and make your paycheck a bit bigger than it is now.
I encourage you to look at what you are giving to the IRS free of charge and work on getting that money back on a bi-weekly basis (i.e. on your paycheck) rather than waiting until the first part of each year to receive it. That extra money has the potential to change your life.
What would you do with extra money on your paycheck? Would you rather receive a large refund? I’d love to hear from you!
FREE Download: 5 Money Tools You Can't Live Without
This list just made life a whole lot easier.
A huge personal finance nerd, Tim studies everything he can on the subject with the goal of achieving financial freedom and sharing that knowledge with others. In September 2016, he finished paying off $26,000 in debt in less than a year!
When not looking at his budget, he can be found spending time with his wife and two little girls, as well as (always) planning his next Disney trip.
Latest posts by Tim Jordan (see all)
- Excited About Your Tax Refund? Here’s Why You Shouldn’t Be - February 9, 2017
- 17 Brilliant Ideas to Pay Off Debt Faster than Ever in 2017 - January 14, 2017
- Personal Finance Lessons I Learned by Mowing My Lawn - November 19, 2016