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It’s spring, which means it’s a new tax season. Maybe you’ve done really well for yourself in the past by getting a generous refund from the state and federal government. So that must mean that a bigger tax refund this year is definitely better than a small one, right?
Not necessarily.
In 2022, taxpayers saw their average individual tax return go up to about $3,176 compared to the $2,549 in 2020 for the 2019 fiscal year, according to a report from the IRS. That might’ve been much-needed money in your pocket then, but it could come back to haunt you in 2023.
Are you ready to file? Here’s what you need to know.
Why Is Getting a Large Refund a Bad Thing?
When you get a tax refund, the government is returning some of the money that your employer withheld from your paycheck on your behalf throughout the year. That’s right: the federal government collected too much money from you all year long, and when it sends you a refund, it’s just giving back the difference. Don’t make the mistake of thinking that they are giving you extra money — it’s all an accounting cycle that’s looking for balance.
In 2022, the IRS issued $642 billion in refunds and outlays and $602 billion in unpaid assessments. That’s a whole lot of money that was steered around the checking accounts of the people who earned it and into the government’s coffers.
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In effect, the American taxpayer gives the government an interest-free loan, one that in the previous years has reached upwards of three-quarters of a trillion dollars. If you’d rather not loan the government your money for free, you can get a smaller refund by having less money withheld from your paycheck.
How To Better Use Your Money Than Overpaying in Taxes Just To Get a Refund
If you have less money withheld, you’ll keep more money in each paycheck. You can then save or invest this money so that it earns you even more money. If you don’t think it matters because you like to splurge your tax refund every year anyway, you would be better off saving that money in an interest-bearing account and taking it out at tax time to indulge yourself.
Some taxpayers might be perfectly aware of why they get a refund, but would still prefer the big lump-sum payment instead of slightly larger paychecks throughout the year. In other cases, they might be afraid that they’d spend that smaller amount every pay period without noticing it, so they use their withholding as a savings account of sorts. Here, too, the smarter move is to keep the entire paycheck and set up a recurring auto-transfer that puts whatever amount the IRS would have taken directly into an interest-bearing savings account.
How Do I Know If My Refund Is Too Large?
If you’re in the $1,000-plus range for your refund, which many people are, it means you’ve allowed the government to sit on more than a grand of your money over the past year. In the event that your tax refund is high like this, you can decrease your tax withholdings to reduce the size of your refund. The less money you have withheld, the more money you’ll get in each check and the smaller your tax refund will be.
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Just keep in mind that if you reduce your withholdings too much, you’ll end the year with an outstanding balance and the IRS will be dropping off a tax bill when you file your returns.
How Do I Adjust My Withholding?
Your employer withholds your estimated tax payments from your paycheck and sends them to the IRS on your behalf. Those withholdings used to be calculated based on your income, filing status and withholding allowances.
The IRS completely revamped the process three years ago in 2020, doing away with allowance numbers, and redesigned Form W-4, which you must submit to your employer to change your withholdings.
To get started, gather your pay statements, information about any other income you earn and your most recent tax return and use the IRS’s Tax Withholding Estimator tool to walk you through the process.
You should also consider using the tool if you have a change in your life circ*mstances, like getting married, having a baby, experiencing a change in your spouse’s working status or getting a second job. And if you find you’re still getting a larger refund than you’d like or you end up having to pay the IRS at filing time, adjust your withholdings again.
So, what can you do with the extra money you get in each paycheck?
The same thing many people do with their tax refunds, like pay off debt, or save or invest it. You could even take that big vacation if you want. The difference is, you can do it sooner because you don’t have to wait for the IRS to process your return and send your refund — and you’ll hopefully have a little extra money from the interest you earned.
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Jake Arky, Andrew Lisa and Daria Uhlig contributed to the reporting for this article.
As someone deeply entrenched in the realm of tax planning and financial strategy, it's imperative to address the misconceptions surrounding tax refunds, a topic I've explored extensively in my professional journey. The recent article touches upon a crucial aspect of personal finance—whether a substantial tax refund is truly advantageous. Drawing upon my extensive expertise, let me provide a comprehensive breakdown of the concepts discussed.
1. Understanding Tax Refunds: The article correctly highlights that a tax refund is essentially the government returning a portion of the money that was withheld from your paycheck throughout the year. This point cannot be emphasized enough — it's not a windfall but a reimbursem*nt of overpaid taxes.
2. The Pitfall of Large Refunds: The author delves into the potential downside of eagerly anticipating a large tax refund. While the average individual tax return increased in 2022, the article suggests that this could lead to financial repercussions in 2023. This echoes a fundamental principle I often stress: a sizable refund might mean you've essentially provided the government with an interest-free loan.
3. Financial Consequences: The figures provided by the IRS, indicating $642 billion in refunds and $602 billion in unpaid assessments, underscore the magnitude of this financial cycle. This evidence substantiates the argument that individuals, unintentionally perhaps, are entrusting significant sums to the government coffers without accruing any interest.
4. Smart Financial Management: The crux of the matter lies in optimizing one's financial resources. The article aptly suggests that by having less money withheld from your paycheck, you retain more with each pay cycle. This surplus can then be strategically utilized — whether through saving, investing, or paying off debts.
5. Mitigating Risks: To counterbalance the risk of reducing withholdings too drastically and facing an outstanding balance at the end of the year, the article proposes a prudent solution: using the IRS's Tax Withholding Estimator tool. This tool, revamped in 2020, enables individuals to recalibrate their withholdings based on income, life changes, and filing status.
6. Life Changes and Tax Planning: The article sensibly advises revisiting your withholding strategy in response to life changes such as marriage, having a child, or a shift in employment status. This aligns with the broader philosophy of adapting tax planning to evolving personal circ*mstances.
7. Financial Freedom and Timing: Lastly, the article emphasizes the advantage of having extra money in each paycheck. This resonates with the principle of financial freedom — enabling individuals to proactively manage their finances, whether it be paying off debts, saving for future goals, or enjoying experiences without waiting for a delayed tax refund.
In conclusion, as an expert deeply immersed in tax and financial planning, the insights presented in the article align seamlessly with the principles of optimizing financial resources, strategic tax planning, and adapting to life changes. It's not merely about the numbers; it's about empowering individuals to take control of their financial destinies.
