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How A Large IRS Income Tax Refund Hurts You
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
Number of Payments
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
Number of Payments
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.
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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