Getting a big tax refund check may be a great feeling, but the ugly truth is that it’s a poor investment decision. It is much wiser to receive those funds throughout the year so that your investment options are multiplied, interest is compounded, contributions can be more frequent and most importantly, so you don’t spend your tax refund all at once!
Throughout the year, your employer withholds a percentage of your income to help you pay government taxes. When you receive a refund, it means you are withholding too much and you overpaid. By doing this, you are giving the IRS an interest-free loan on your money, because you’ve let them “borrow it” over the year until they give back what you don’t owe. After checking out the advice of some other financial bloggers, I’ve learned there is much more strategy to withholding taxes than I realized.
Like most people, I look forward to a large refund because it’s like a whole other paycheck plus some (okay, a lot). However, it’s not “new money” because it was mine in the first place… I’m just getting it back. Instead of loaning unnecessary funds to the government, why not look into withholding less? If you change your withholding allowance to a lesser number, your refund will be smaller, but you’ll also have that additional income throughout the year instead of in one lump sum.
In my crash course, I learned that a tax allowance is a number claimed on your W4 and depicts how much of your true income will be withheld throughout the year. The most you can contribute to a tax allowance is classified as 0, so the higher the number, the less you are withholding. It is common to have a withholding tax allowance of 0, 1 or 2. This number is specific to you and your needs.
With the New Year and tax season gaining steam, now is the perfect time to reevaluate your current withholdings on your W4. If your anticipated refund for 2010 is a high dollar amount, take the opportunity to see if you’re in a good position to adjust your tax allowance for 2011. The IRS provides a withholding calculator to see what the right tax allowance is for you. Your ultimate goal is to receive a small refund ($100 bucks or so) by withholding just a little more than what you anticipate to pay, but be careful! If your withheld tax allowance is too low, you could end up owing. If you’re unsure about using a withholding calculator or anticipate drastic changes that could affect claims on 2011’s taxes, you should consider meeting with a tax professional. I am not one, nor do I claim to be.
If you’re lucky enough to be receiving a chunk of a tax refund for 2010, take advantage of the returned income and invest or save it wisely (you can always keep out a small portion for some fun spending— even I’m doing that!). Then, research a change. Play around with the withholding calculator and get a professional opinion on adjusting your W4 for the next year. This can be handled by your company’s HR or payroll department. Next, explore your investment options. Your refund for 2011 will be smaller, but the adjustment gives you more of your true income every month of the year. It may not evoke the same “big check” feeling, but a little extra funding each month goes a long way.