Is receiving a tax refund every year financially sound?

Banking Pictures While it's always fun to get that refund check in the mail, it may not be cause for celebration after all. See more pictures of banking.
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Big tax refunds are reason for celebration. Or are they? It's understandable you'd be excited about a large tax refund. After all, it almost feels like found money! Of course, it isn't found money; it's money that belongs to you as the taxpayer, and the cash was simply delayed in making its way to the rightful owner's hands.

There are three common reasons why we receive large refund checks year after year. The first is that we just aren't paying attention. In our busy lives, we may not be focused on making changes that would better balance taxes withheld compared to taxes refunded. If it's not broken, why fix it, right?

The second reason is that we may not realize the implications. We may have never been taught that a large refund isn't necessarily a good thing.

The third reason is that some believe having a lot of money withheld from paychecks and refunded later is a sort of forced savings plan. Unsuccessful savers may welcome the opportunity to trick themselves into saving money.

But what are the implications of a larger-than-needed tax refund?

 

Large Refunds Cost Money

When you, as a full-time employee, fill out a W-4 form that dictates how much money should be withheld from each paycheck for taxes, most experts will advise that you select the exemption number that will get you closest to a zero balance on April 15. In other words, the total amount held from January through December should equal, or be very close to, the tax bill amount revealed in April. If you opt for too many exemptions, you may owe above and beyond what you already paid in withholdings, and you'll have to write a check and possibly pay a penalty. If you select too few exemptions, then you get a big refund, but you relinquished control of that money over the course of the year.

If you opt to obtain more balance of your withholdings versus your tax refunds, you gain the opportunity to do the following:

  • Earn interest. You (rather than the IRS) can earn interest on that money. Even when interest rates are low, interest is income. When rates are high, having that cash in an account can make quite a difference.
  • Invest. With the extra money in your paycheck, you can make some good investments that can make a significant improvement in your financial future.
  • Reduce debt. Do you have a credit card balance? Lowering tax withholdings and retaining more of that paycheck will allow you to start paying down expensive debt.
  • Save for rainy days. Put away a little extra money for later.

Explore Alternatives

Look for ways to stash your extra cash so you can keep more of each paycheck.
Look for ways to stash your extra cash so you can keep more of each paycheck.
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Are you ready to take action? If you decide retaining more of your paycheck is better for your financial future, but you're concerned that you might spend the extra money, there are some great options. An automatic payment using online banking or a payment service such as CheckFree can remove the money before you have a chance to burn through it.

You could set up an automatic payment that takes money out of your checking account and puts it into a savings account, and you can watch that savings account grow. You may instead want to set up an automatic payment toward high-interest loan accounts. Paying off credit cards, for example, can save you substantial amounts of money when you stop paying those high interest charges. You can also set up an automatic payment to have that extra cash go toward your IRA contribution, which earns you money and lowers your tax bill.

Alternatively, if you believe you can refrain from spending the extra cash, then enjoy having a bit of spare money around. It's handy when it comes to needed home repairs, family vacations and maybe even a little surprise for yourself!

For more tips on taxes and finances, check out the links on the next page.

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Sources

  • Davies, Wayne M. "5 Reasons Why You Should NOT Get A Big Tax Refund." Insider Reports. (Jan. 5, 2011) http://www.insiderreports.com/storypage.asp?StoryID=20006798
  • Updegrave, Walter. "3 ways to use your tax refund." CNNMoney.com. March 18, 2010. (Jan. 5, 2011) http://money.cnn.com/2010/03/18/pf/expert/investing_tax_refunds.moneymag/index.htm