Excited About Your Tax Refund? It May Not Be Worth the Deferred Earnings

You may have heard of the trick of keeping your credit card in a bowl of ice in the freezer to make it harder to swipe the plastic. But what if there was another way to avoid credit spending—simply by getting bigger paychecks? It may be possible if you’ve been over-withholding on your taxes.

The U.S. government issued more than 111.8 million refunds last year. They went to around 72% of taxpayers, and averaged $2,869 apiece, according to the Internal Revenue Service (IRS). Direct deposit refunds averaged closer to $3,000.

For some people, a tax refund could be larger than a regular paycheck. And taxpayers often use their refund money to pay off debt or put into savings.

According to a March 2019 TurboTax survey:

• 58% of households with an income of less than $50,000 rely on their tax refunds to pay off debt
• 41% of households making more than $50,000 use the money to pay down debt
• 43% of Americans who receive a tax refund put it into savings

What Is Federal Withholding?

If you’re a typical W-2 employee, you filled out Form W-4, which lets your employer know how much money to withhold from each paycheck in the form of “allowances.” In general, the more allowances you claim, the lower the amount of tax that will be collected and sent to the IRS.

You can claim between zero and three allowances. Do you have several children, or are you expecting other tax credits that will lower your overall tax burden? You might consider upping your allowances. Conversely, some taxpayers with both W-2 and self-employed income choose to over-withhold on their W-4 in order to compensate.

Others choose to lower their allowances in order to overpay at the federal level, knowing they’ll be getting it back in the form of a higher tax refund. But is that a good idea?

Know What Type of Spender You Are

Why might someone allow too much money to be withheld from their paycheck each month? “For a lot of people, [over-withholding] is a forced savings,” said Lisa Greene-Lewis, a tax expert with TurboTax and a certified public accountant.

For people who know they’re not going to use the money wisely—such as on expensive coffee drinks or shopping sprees—over-withholding can be a good thing, Greene-Lewis explained. “Not everybody is a good saver,” she added.

Others opt for less money to be withheld and don’t get as big of a refund. According to the TurboTax survey, 64% of those age 45 to 54 opt for this route, while 52% under the age of 45 do so.

“Checking your withholding can help protect against having too little tax withheld and facing an unexpected tax bill or penalty at tax time next year,” according to the IRS. “At the same time, you may prefer to have less tax withheld up front, so you receive more in your paychecks and get a smaller refund at tax time.”

Greene-Lewis said people should revisit their W-4 forms each year to check that they’re happy with what’s taken out of their paycheck or make adjustments if they wish. Changing tax laws, a new job, an increase or decrease in income, or the birth of a child could be reasons to change your withholding.

One way to optimize your withholding is to use the IRS Tax Withholding Estimator. 

Alternatives to Splurging

If you opt to receive more money in each paycheck, you could consider investing that money in a retirement account throughout the year instead of waiting to get your refund. In addition to bulking up your retirement savings, by contributing to an IRA or 401(k), your federal tax bill is reduced now (the taxes are deferred until later).

If you have a lower income, you may be able to use the retirement savings contributions credit, also known as the saver’s credit, to claim up to $1,000 ($2,000 if married and filing jointly) for making eligible contributions to your IRA or 401(k).

When it comes to taxes, refund time can seem like a bonanza. But it’s really not a free windfall. It’s your money, and you worked hard for it. If you’ve been over-withholding, you’ve essentially been loaning it, interest free, to Uncle Sam.

So if you have the opportunity to reduce your withholding, you may want to consider doing so. Just remember to be diligent about saving the difference. And if you’re keeping more in each paycheck, you might be able to free up some space in your freezer, knowing that you’ll use the credit card more wisely.