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The problem with that large tax refund

By Jennifer Goforth Gregory

The problem with that large tax refund

I excitedly told my father that I was getting a large tax refund, expecting him to be as happy as I was. I was 22 years old. I had been working at my first professional job for less than a year and struggling each month to pay rent. To me, the $4,500 IRS check headed my way was the equivalent of winning the Powerball lottery.

But instead of being happy for my windfall, my father, who has worked his entire career in the financial and banking industries, gave me a gentle but firm lecture about how I had given the government an interest-free loan on my money.

Who doesn't like lump-sum payments?

I was not alone in my joy over a large refund. According to a March poll from the National Foundation for Credit Counseling (NFCC), 58 percent of people intentionally receive an income tax refund instead of keeping a larger portion of their take-home pay throughout the year. But as my dad so wisely pointed out, this really isn't the best financial move.

Instead of saving my large refund, I ended up spending it on a vacation. Had I made wiser tax elections, the extra money I would have received throughout the year could have made the difference between comfortably paying my bills and the sleepless nights I spent worrying about money.

While the beginning of the year is the ideal time to make adjustments to your withholding, many people don't realize that their current withholding are netting a large refund until tax time. But making modifications in March or April still can help you increase the amount of money you have throughout the year and decrease the amount you are lending to the government in 2013.

The NFCC offers the following tips for those who received a refund for the 2012 tax year:

  1. Use your 2012 tax refund to boost your emergency fund. Make sure that the money is in an interest-bearing vehicle, such as a savings account or CD. Unless you have an overflowing emergency fund and all of your debt is paid, resist the urge to head to the mall or buy a plane ticket.
  2. Calculate your proper amount of W-4 withholding allowances. Use the IRS Withholding Calculator to determine the right amount for your situation. Make modifications to your withholding with your employer and encourage your spouse to do the same. If you have any life events during the year, such as a birth, death or divorce, update your withholding with your employer.
  3. Determine a plan for responsibly using the extra money you will have in your paycheck each month. If you simply use the cash to increase the entertainment portion of your budget or buy the latest fashions, then you are missing an opportunity to move closer to meeting your financial goals. Paying bills, paying off credit cards and establishing the ever-important emergency fund are all great uses for the extra income.

So if you find yourself getting a refund of more than a couple hundred dollars from the IRS this year, take a few minutes to evaluate your tax strategy for next year. Instead of getting a large refund as I did many years ago, I have a very small check coming my way this spring. I think I will give my dad a call. He will be proud.

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3 Responses to “Why Large Tax Refunds Are Bad for Your Finances” 

  1. Reputo says:

    It's actually more complicated than you or your father make it out. While you may be giving an interest free loan to the government, this has to be weighed against the potential for tax underpayment penalties for not having enough withheld. If someone has a fairly consistent stream of income from year to year (possible) and the tax system doesn't have many changes (unlikely), then a simple readjustment of the withholding amount can correct this so that you don't get a large refund. However, the AMT (and subsequent AMT "fixes") each year make it rather difficult to estimate what your tax liability will be until the end of the year. For instance, this year the preliminary software analysis I did in December showed that I would owe the AMT and have to cut the IRS a check for $250 because not enough was withheld. However, Congress passed some fixes in early January and the final software showed I would receive a refund of $5000. Ultimately, it boils down to how much your time is worth and whether the payoff (interest or investment income from that big refund) is worth the extra time you are going to have to put in over the year to keep your refund low. I go through my scenario at my blog and conclude that it isn't worth it - http://myreputo.blogspot.com/2013/03/my-tax-return-savings-account.html

  2. Caesar F says:

    So basically it seems like the only problem with getting a large tax refund is the fact that you won't save it? If so, it's more of an individual problem wouldn't it be?

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