By Kate Horrell
It’s tax season, and I’ve heard lots of people who are excited about the big tax refunds that they are expecting. While it’s fun to get a windfall of money, there are at least five good reasons why a big tax refund is a bad idea.
Refunds can be delayed or messed up
Refunds don’t always come on schedule. They can be delayed because of new policies, or the Internal Revenue Service (IRS) thinks they’ve seen an error in your tax return.
This year is a great example of expected delays. For the 2016 tax filing year, the law requires the IRS to delay the final processing of refunds that claim the Earned Income Tax Credit (EITC) or Additional Child Tax Credit (ACTC.) These refunds will not be finished until at least February 15, 2017.
Errors can take even longer. In 2011, my family was expecting a big refund on overpayment of taxes. The IRS thought that we were not eligible for a credit that week took, and we spent almost two years of finagling with the IRS before we got things sorted out.
If you’re planning your budget around doing something “when we get our tax refund,” you could be in a sad situation if that refund is delayed.
Refunds can be garnished
Tax refunds can be garnished (taken) to pay a wide variety of debts, including unpaid student loans, unpaid income taxes, child support, alimony, and interest and fees on previous tax returns. Many times, the taxpayer doesn’t know this is going to happen and is expecting a refund. Instead, they get a notice that their refund has been garnished to pay their debts.
While I am in favor of paying your debts, I don’t recommend tax garnishment as a way to make that happen. There are a lot of things that can go wrong. Perhaps you’ve already paid off your student loan but a bookkeeping error was made and the loan company thinks you still owe. If your tax return is garnished in error, you will have a doubly hard time fixing the problem.
If you don’t get a tax refund, you can’t have it garnished.
It’s not a great cash management plan
If you receive a large refund, it usually means that you’ve been having too many taxes withheld during the year. Your overall budgeting would be better if you have a smaller amount withheld and a slightly larger check every payday.
Let’s take the example of Sam Sailor who gets a $1,200 tax refund. He’s been struggling to pay his bills all year and finally catches up when he receives his tax refund. Wouldn’t he have been better off with the extra $100 in his paycheck each month?
The IRS doesn’t pay interest, but you do
If you’re overpaying, then you’re basically giving the federal government a free loan of your money during the year. If you have debt of any kind–including car loans, credit cards–or student loans, you’re paying interest on that debt. Financially, it makes more sense to pay off your debts instead of loaning the government money.
Let’s say that Airman Aaron has a credit card with a balance of $1,800 and a 10% interest rate. He’s having too much withheld from his taxes, so he can only afford to pay the minimum payment each month. That 10% interest will accrue and even though he’s been making payments each month, he’ll still owe about $1,800 at the end of the year (exact amounts will depend on his minimum payment amount.) He then takes his income tax refund and pays it off. He’s paid around $1,965 for that debt.
Instead, he could adjust his withholding and receive the extra $150 in his paycheck each month. By paying off $150 of this bill each month, he’d have just $87 left at the end of the year, and he’d pay just $1887 in total. This is a savings of $78 over the year. If you’re talking about larger amounts of money, higher interest rates, or getting a big refund year after year, those numbers could really add up!
People Tend To Overspend Tax Refunds
Many people overspend what their brains consider to be “bonus” money. . . and income tax refunds fall into this category. It’s due to a glitch in the way our brains categories sources of income and it’s dangerous. Studies show that money that is received outside of regular income is likely to be spent less sensibly than regular income and that we tend to mentally account for it more than once.
Let’s say Marine Mark gets an income tax refund of $800. He might go out and purchase a new television for $500, and then spend $200 on a gift for his wife, then spend $400 on a weekend out with friends. Suddenly, he’s spent $1100 and it’s all been mentally accounted to his $800 tax refund. That’s not good!
How to stop getting a big tax refund
When you get a big tax refund, it is because you had too much money withheld during the tax year. The best way to solve this problem is to change the amount of money you are having withheld from your paycheck. Your employer calculates your withholding based on the instructions you provided when you filled out your IRS Form W-4– Employee’s Withholding Allowance Certificate. You can change your W-4 withholding instructions at any time. Ask your employer how to do it. They may want you to fill out a new paper form or they may have a system to do it online. If you are military, it is quick and simple via the myPay system.
How much do you want to have withheld? The IRS Withholding Calculator is a good place to start. It is online and interactive, and will help you figure out the right withholding for most situations. If you have a very complicated tax situation, you may want to delve further into the tax withholding worksheets on page 2 of the IRS Form W-4 or explore the various worksheets available in IRS Publication 505, Tax Withholding and Estimated Tax.
Withholding needs change with various life events. You’ll want to check your withholding whenever you:
- get a raise
- start a new job
- add a second or third income
- have a baby or have a child move off of your income tax return
- get married or divorced
- buy or sell a house
- turn a house into a rental
- start a small business.
Getting a big income tax refund can seem like a great thing, but there are good reasons why you should celebrate your small tax refund. A small refund, or even needing to pay a little, means that you are having the right amount of money withheld during the year. You’ll have more accurate cash flow and your refund won’t be threatened by delays, errors, or garnishments.
If you’re getting a big refund this year, take a few minutes to adjust your withholding today. If you’re not sure how to do that, or how many allowances you should be claiming, get some help. On base, your family service center (Airman and Family Readiness Center, Army Community Services, Fleet and Family Service Center, or Marine Corps Community Center) has a financial counselor who can help you figure it out.