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Why Bigger Tax Refunds Aren’t Always Better
A big tax refund can be nice to receive, but it usually means less money in each paycheck. Instead, adjust your W-4 and put that money to work for you throughout the year.
Tax season is in full swing, and many Americans are eagerly awaiting their refunds. The United States Internal Revenue Service in 2018 refunded more than $312 billion, with an average refund of about $2,825 — not small change.1 While some look forward to the annual spring windfall and may have it spent before the check is in hand, that refund may not always be cause for celebration.
“If you’re getting a large refund check, that means you’ve essentially loaned money to the U.S. government throughout the year, and they’re giving it back to you without interest,” said Glenn Powell, a financial advisor with PNC Investments.
There are pros and cons to receiving refunds, but if you had that extra money in your paycheck, rather than funneled to the IRS and then returned at tax time, it could help you achieve some of your financial goals. Here’s how:
- Pay down high-interest debt. Focus on credit cards with the highest interest rates first. Using some of that extra cash each month to pay off a balance with an 18 percent interest rate is like earning 18 percent on your investments, Powell said. You’ll be helping yourself in the long run, and improving your credit score at the same time.
- Start or increase your emergency fund. A good rule of thumb is to put away enough cash to cover at least three to six months of living expenses in case of an emergency, Powell said. If you've had to withdraw money from your emergency fund, use that extra money in your paycheck to start rebuilding it. This "stash" should be easy to access — in a money market account or savings account, for example — if you need it.
- Boost retirement savings. If you’re focused on retirement or another long-term goal, put the money in your 401(k), retirement plan or a Roth IRA. "If your employer offers a retirement plan and you’re not participating in it or not contributing enough to receive a full company match, you're missing a great investment opportunity," Powell said. "There's no faster way to grow your money."
- Save for your child's education. If you have young children, starting or adding to a college savings plan — such as a 529 plan — makes sense, he said. The money can be used tax-free for tuition bills, and you could get a state income tax deduction for your contribution.
- Invest in yourself. Didn’t think you had the funds to join a gym or save for a dream vacation? With a little extra going into your pay rather than being withheld, maybe you can.
- Give to others. If you have your financial bases covered, consider earmarking the extra funds for charitable contributions. You'll feel good and be rewarded come tax time.
How to Fix it? Update your W-4
If you’re getting a few hundred dollars back in April, there’s no need to rush to adjust your W-4 — the form that tells your employer how much of your paycheck to withhold in taxes. But if your refund is closer to $1,000, $2,000 or even higher, Powell says you might want to consider making some adjustments.
On the W-4, you can claim exemptions for dependents, having a non-working spouse or paying for child care, among other things. So, remember to change your W-4 after a life event, such as getting married or having a baby.
The more exemptions you have, the less earnings will be withheld from your paycheck in taxes. As a result, you may owe money come tax time. On the other hand, the fewer exemptions you claim, the more your employer will withhold from your paycheck. If your tax refund was rather large, you likely aren’t taking enough exemptions.
In 2018, the IRS was responsible for:
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