The IRS sends out nearly 100 million income tax refunds each year. That’s a lot of money! If you’re like most taxpayers, you’re probably familiar with the drill. You have taxes withheld from your paycheck all year and then come March you begin to prepare your taxes so that you can get that tax return. Since the average tax return is a little over $2,000, this is real money that can go toward a number of important financial issues in your life.
Why You Get Tax Refunds
So, why do most people get a tax refund? Well, the US tax system is pay as you go. This means you pay taxes on your income as you receive them. Since most people are employed and issued regular paychecks, the income tax is automatically withheld. The amount that is withheld is based on how much you make as well as how many allowances you’ve claimed on your W-4. This is the form you fill out when you get a new job that asks how many dependents and exemptions you have so that the taxes withheld are accurate.
The problem is that most people don’t fill out their W-4 accurately and that can lead to having too much withheld from each paycheck for taxes. After a full year goes by you may have paid the government more than your fair share of taxes, so the result is a refund once you file. It’s not just an incorrect W-4 that’s the issue, because there are countless tax credits and deductions that aren’t factored in that can also result in having too much withheld.
Why Having the Correct Tax Withholding is Important
Ideally, you’d like to have your income tax withholding match the amount that you’ll owe the IRS each year. This would mean come April 15th you would not owe any money or get any money back as a refund. You’d basically be putting as much money into your pocket with each paycheck as possible.
When you withhold too much, you’re basically getting paid less with each paycheck. Then the excess money going to taxes is sitting with the IRS for the better part of a year unavailable to you. In essence, the government is getting an interest-free loan from you. If you had the excess money going towards taxes put in your own pocket you could apply that money to credit card debt, fund a retirement account, or even earn interest if it was put into an emergency fund. Instead, the government takes your money and locks it up for a year until you finally get that refund.
It’s bad enough to give the government an interest-free loan, but things can be even worse if you don’t have enough money withheld. In this case, you haven’t paid enough in taxes as you went along throughout the year and come April 15th you’ll have to cut a check to the IRS. Ouch! Nobody likes an unexpected bill like that. So making sure you have enough withheld is just as important as making sure you don’t have too much.
What to do if You Have a Big Refund Coming
What are your options if you find yourself getting a tax refund? First, you should check with your employer and file an updated W-4. Things may have changed in your life since you started working such as getting married or having children which could have changed what you should be claiming. The W-4 has a worksheet to help guide you. Once you’ve updated your W-4 you should begin having the correct amount taken out of your check.
If you have done that and still get a refund, that’s ok. It isn’t the end of the world and some people even feel that getting a tax refund each year is a way of forced savings. This can be true as long as you use your tax refund wisely. If you take your tax refund each year to contribute to an IRA, pay off debt, or build up your savings account, that’s great. But if you’re someone who treats the refund as found money and blows it on a new TV or an unnecessary expense you’re not really doing yourself any favors.