3 Reasons why Tax Refunds are Bad & how Allowances can Help
By G.E. Miller • Mar 2nd, 2008 • Category: Taxes, Workplace Finance
The Psychology of the Refund
It’s that time of year when many people start to get giddy about getting that fat tax refund they’ve been waiting for. According to the IRS, the average tax refund last year was a whopping $2,771. Surely, visions of Vizio HDTV’s, a new Macbook, and home theatre systems are dancing through the heads of many. What many of us, particularly younger professionals, don’t realize or don’t want to accept, is that getting that huge refund is really a poor financial strategy.
The reason why anyone would be able to receive a huge refund is mostly going to be due to the fact that they were paying the government too much withholding tax on your income throughout the year in the first place. A lot of people realize this, but don’t seem to want to take action. Personally speaking, I have fallen into that psychological trap as well, where you think by getting a large refund you are somehow better off financially for it. Getting that large check in the mail feels like a huge blessing. Quite the opposite is true.
The Drawbacks to getting a Large Refund
1. You are loaning your money for a negative return. Getting a large refund means you are paying more in taxes throughout the year. This money could easily be going into your bank account and earning interest throughout the year. Let’s say that you invest the extra income in mutual funds and you earn the stock market historical average of 13.7% on your extra income, in effect you’re loaning the government your cash and in return for your kind offer you are giving them 13.7% of your cash. Even if you just put the money into a high interest checking account that returned 4% a year, consider it a 4% loss on the amount of your refund.
2. You are binging and purging your cash. Getting more of your true income delivered to you on a consistent basis allows you to work it into your budget. If you direct deposit this income into your savings, you don’t miss it at all. The urge for many, when they receive a big refund, is to go out and spend it because they feel that they deserve it. They do, after all, it’s their hard earned cash! If you set yourself up to not get that big refund, there’s no urge to purge.
3. You are not able to distribute investment risk evenly over time. Part of any good investment strategy is to distribute risk of loss buy adding investment contributions over time. Even if you wisely invest your refund versus spending it all, you would most likely be making one large contribution versus spreading out risk over the year. This is a bad investment practice.
The Basics of Withholding Tax Allowances
A withholding tax allowance is simply a number than you can claim on your W4 form that will change the amount of your income that your employer will withhold from you throughout the year. The number of allowances can vary, but is most likely 0, 1, or 2. The higher the allowance number, the less tax will be withheld from you with each paycheck. A W4 is filled out by an employee when they start employment. Allowances on a W4 can be updated at any time by filling out a new one. Most employers will allow you to do this whenever you desire (and as often as you desire), and your withholding tax amounts should take effect in your next full pay period (this may differ by employer, so ask yours).
Your End Goal
Ideally, at the end of the year, you will benefit the most if you receive a very small refund (close to nothing) or end up paying a very slight amount that you will be able to easily pay. One caveat when changing allowances: the last thing you want to do is end up with too high of an allowance that results in you owing a high amount that you are unable to pay.
How can I Figure out what my Allowance should be?
Fortunately, there are at least three free resources available to you, which are cited below. If you still are having trouble figuring out what your allowance should be, you may want to speak with your employer’s payroll department or a qualified tax professional.
IRS Publication 919 - this includes the official withholding allowance worksheet, as well as a W4.
Intuit Turbotax tax tools and calculators - includes tax estimator and withholding allowance calculator.
H & R Block withholding calculator
Will you be changing your allowances in the coming year?
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Great insight G.E. I’ve always received a tax return and placed it directly into savings or an investment vehicle. It never clicked that I could be using the added income over the year to better take advantage of dollar cost averaging. I do, however, eat Vizios for breakfast.
Thanks Dan. You know what they say - “A Vizio a day keeps the doctors away”.
Ahahahahahaha! Great, great.
Being my first year employed I had no idea what I was picking when I did the allowances. I ended up going with 3. I guess that was a good move!
Three is pretty high, how much did you end up owing? The one thing that should be avoided is owing so much that you actually incur an interest penalty.
Federal tax I didn’t owe anything. Got $400 back. State tax I owed $181.
Excellent, that’s right where you want to be. Unless you significantly change your 401K contributions or change jobs, you probably don’t want to change a thing.
I am married with 1 child and I am the only one working. I brought in about 48K last year and received close to 6k in my refund. I used the IRS calculator and it told me to change my withholdings to 8! Is that correct? It stated that I would get about $75 back next year if my financial situation did not change. 8 just seems like too much…
Wow, I’ve seen 3 or 4, but never seen an 8! Pretty impressive, Freddie. I’m surprised with only one child it suggested you to claim that high. Do you have other dependents (other than your wife)? $6K is a huge refund, and in supporting your wife and a child, I’m sure that money distributed throughout the year more evenly to you may come in handy. My suggestions would be to try out a few different allowance calculators, and if they all come back with an 8, then go with it. Receiving a $75 return is a good scenario. If you’re still feeling a little weird about it after that, then you may want to consult with a CPA.
I agree with Dan - thank you so much for #3! I have received my refunds back, but stuck them in a savings account to deal with later, intending to put them in my Roth IRA when I get around to it. Now I’m thinking maybe I’ll just increase my Roth contribution to spread that out over time instead of making a lump sum contribution - I definitely would not have thought about that before reading this article.
Also, I have known for a few years that letting the government keep your money interest-free all year is not beneficial, but this past year is, I think, the first year I’ve ever had where I actually would have invested or saved it had I been paying less in taxes. So how do I change my withholding for the rest of this year to try to get more of my money for the rest of the year? Or I guess maybe I should just contact my Human Resources Department and ask them. . . lol.
Hi Stephanie, yes, I’d recommend trying out the calculators to see what they recommend, and then speaking with your H.R. department - they’ll be able to help you with changing your allowances, which you should be able to do at any time throughout the year.
ppl tend to blow their tax refunds
but, ppl tend to blow pay checks too
Question: Can I claim a really high amount of allowances in order to more closely estimate my final tax liability? I will only be working for a few months and don’t want to pay taxes every 2 weeks where the withholding is based on an estimate of what I would make if I worked for the rest of the year. I used a tax calculator and figued out that if I claim 14 allowances my bi-weekly withholding will be just slightly over my end-of-the-year tax liability (giving me a very small return), which is exactly what I want. My only concern is that the IRS is going to take notice of my claiming 14 allowances…
@ J.D. - it looks like you’ve run the math, but as to whether or not the IRS will take notice of 14 allowances, I’m not quite sure. If it’s something you’re concerned with you may want to consult a tax professional, I’d hate to lead you astray.