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How A Large IRS Income Tax Refund Hurts You

Updated on January 11, 2013
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Many Americans look forward to filing federal income taxes each year. Why is that? Simply because of the joy of receiving a large refund from the IRS. When taxpayers know that they will receive a lump sum deposit of $4000, courtesy of the government, they somehow feel that they are beating the system. Well, not so fast!

Where did that monster refund really come from?

First, understand clearly…the government is not giving away free money! Most Americans are employees and get a W2 toward the end of January with which employees use to file income taxes by April 15th. In block two of the W2 is the dollar amount that was withheld from hard earned wages for taxes in the form of withholding. This dollar amount is what was told the employer to send to the government in the form of taxes on the W4 form. It is money that if workers elect to withhold too much, they delay the use of until taxes are filed.

As an HR professional, I often hear our employees state that they want as much withheld as possible from their pay in order to get a big refund. I cringe when I hear this because in my role, I am not at liberty to offer financial advice to employees. I desperately want to ask if they enjoy lending out their hard earned money for no interest income in return. When Americans purposely design their paychecks around the large refund that is exactly what they are doing.

I need my refund to pay down debt!

Paying down debt is a typical use of the large tax refund. Let the numbers tell you why that is not a good idea. If you are like so many people who live paycheck to paycheck and wind up charging a few hundred dollars almost every month because “something came up” and you receive a $4000 refund, then you are truly hurting your family’s financial picture. If you adjust your W4 withholding, then you could add $333 every month to your budget! This additional money could help you to abstain from relying on the old credit card to get you out of a pinch. The addition of the monthly income could keep you from going further into debt. The interest that you will not pay the credit card companies adds up too.

If you are not adding to your debt, but trying to become debt-free, and use the refund to work on your debt reduction goals, then interest really comes into play. I could get extremely technical but I will just keep it simple. The following tables illustrate what happens when someone pays the same amount of money in two different ways and the results.

Using Tax Refunds for Debt Reduction

 
 
Balance
$10,000
Interest Rate
18%
Monthly Payment
$250
Interest Paid
$2,314.16
Number of Payments
24

Now if you were to take that extra $333, add it to the $250 that your are already paying, and put it toward the debt every month, it would look something like this:

Using Additional Income Instead of Refunds

 
 
Balance
$10,000
Interest Rate
18%
Monthly Payment
$538
Interest Paid
$1,620.27
Number of Payments
20

Wow! Just a little discipline can put $693.89 in your pocket in interest savings! The point I’m trying to get across is that while it may feel good to pay that large chunk of money all at once, the numbers tell you what the smart thing to do is.

I use my refund to fund my Roth IRA

If funding a retirement account with your refund money is what you plan to do, then congratulations! Not because it’s the smartest use of money, but because you are saving and planning for your retirement. Having said that, using the refund is not necessarily the smartest use of funds.

In a two year example where you start with the monthly deposit of $250 in an IRA that earns 8% and depositing $4000 in months 12 and 24 you will have $14,816.46. Instead of overpaying your taxes to the government, a smart taxpayer can deposit $583 every month for the 24 months. In this example you will have $15,120.22. In only two years! Investing your own money instead of giving the taxman a free loan earns you $303.76! Imagine over a working lifetime how much money so many people are giving up just to get the large refund.

At the end of the day, it is YOUR money

A common argument against practicing the smart uses of your money, which I have outlined, is that people just are not disciplined. I would encourage you to force the discipline on yourself. Do not rely on the government to be your personal, no interest earning savings account in order to feel good when the annual payout comes around.

There are so many things that you cannot control. If you are the recipient of a large refund, I recommend that you change your withholding on your W4 TODAY so that you can take control of your money for a more secure TOMORROW

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    • HoneyBB profile image

      Honey Halley 4 years ago from Illinois

      Excellent advise and something that every taxpayer should read. It makes perfect sense to take your money in your paycheck and not let the government hold it with no interest to you. Investing it yourself in an interest bearing account is a much better plan.

    • JJMargaret profile image

      J Johnson 4 years ago from South Jersey

      Excellent. Congratulations on your second Hub.

    • anitafuse profile image
      Author

      Anita 4 years ago from Larose, LA

      Thank you Honey and Margaret :) Personally, this year is an adjustment year for me as both my husband and I have upgraded jobs and I have a child that will no longer qualify for income tax credit. I am sure I will have to adjust my withholding soon.

    • Weekend Reader profile image

      Weekend Reader 4 years ago

      I wholeheartedly agree that "loaning" the government money during the year is a poor use of your funds. I believe in owing THEM a little money, come tax time! However, there is a significant number of taxpayers who get big refunds for whom adjusting their W4 wouldn't change a thing. These are folks whose household income is under about 40K and the refunds are generated solely by the tax credits they are eligible for.

    • anitafuse profile image
      Author

      Anita 4 years ago from Larose, LA

      Great point Weekend Reader! I had not even considered the tax credits scenarios. Sounds like a research project for an upcoming Hub!

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