Despite the news that more tax paying Americans will have to pay more taxes due to Trump’s “tax cut,” many people are anticipating their tax refund. What has been celebrated as “bonus money,” is actually a financial facade of a bigger issue. The most common cause of a tax refund is tax credits, like the Earned Income Tax Credit (EITC), for low-income households, particularly with children. Also, entrepreneurs and homeowners are able to leverage qualified tax deductions, which can produce hefty tax refunds. However, if you receive a large tax refund, but do not qualify for the EITC and are not a home or business owner, then, Houston, we (may) have a problem, as the saying goes. Here’s why getting a tax refund is not always good.
3 Reasons Why Getting a Tax Refund is Not Always Good:
Gives the Government an Interest-Free Loan
Outside of tax credits, like the EITC, or business and homeowner tax deductions, a tax refund is the payment of overpaid taxes to the government throughout the year by an individual or household.
“Essentially, a tax refund is an interest-free loan that consumers give to the government,” explains Edeline Dryden, CEO of Dryden Tax & Accounting Services.
Cheats You of Needed Cash
As workers wait for their tax refund, they are giving the government the use of their hard earned money to run or “shutdown” the government. This leaves many workers to struggle financially, living paycheck to paycheck throughout the year.
The amount of income from the paycheck withheld for taxes is determined by the W-4 completed when hired. The reality is the last time the W-4 was updated was when the person started their job.
Neglecting to update or complete the W-4 correctly can cause the over payment of taxes to the government.
Dryden suggests “Review and/or update your W-4 at least annually, as necessary. The goal is to keep that income in your paycheck to use throughout the year.”
More Money Magnifies Bad Money Behaviors
As Biggie Smalls said, “More money, more problems.” If a person has poor spending habits, having access to more money will just magnify that bad behavior. Even with good intentions of saving and paying off debt, financial fornicators may surrender to the temptation of excessive spending of the “bonus money.”
“If spending habits are questionable,” Dryden advises “divide the refund into three even categories. These categories can include savings for emergencies, debt repayment, and spending for pleasure or necessity.”
By breaking the refund into these three categories, you will start a savings safety net, knock down some debt, and enjoy some of the cash so you won’t feel deprived.
Dryden also shares a few ways to make sure you get the most out of your paycheck throughout the year:
Adjust withholding to get your money throughout the year
If you have life changes, like a marriage, divorce, birth or adoption of a child, death of a spouse or child, or even an income change (i.e., pay raise); your W-4 should be updated appropriately. This will ensure that your employer is not withholding more than necessary.
“The real winner of the tax game is the person who doesn’t owe taxes or gets minimal or no refund.” Dryden explains, “This means they kept their income throughout the year.”
Dryden recommends speaking with a tax accountant or tax professional for assistance in completing the W-4 correctly.
Use the extra income to pay off debt or build your emergency fund faster
“Use that extra income in your paycheck to pay off debt or to build your emergency savings fund.” says Dryden.
The importance of having an emergency fund was realized when over 800,000 federal workers and contractors did not receive paychecks for over 30 days due to the government shut down. The extra income is an excellent opportunity to build a savings fund for unexpected emergencies, job loss, etc.
The extra income can also be used to pay down debt to produce more future disposable income.
Use the extra income to invest
Some people try to rationalize a tax refund as a forced savings technique.
Instead of giving the government an interest-free loan, keep that extra income throughout the year to invest and earn more money.
“Increase your contribution to your Employer-Sponsored Retirement Account, like a 401K, 403B, 457, Thrift Savings, etc.,” recommends Dryden. “Or set up a direct deposit or automatic transfer to a brokerage account. Instead of buying stuff — buy stock.”
Dryden recommends speaking with your employer’s retirement investment administrator or a licensed investment adviser for assistance with stock investments.
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