How a Tax Refund Can Cost You More
Can You Lose Money By Getting a Refund Back?
When tax season comes around, it's inevitable to feel excitement if the IRS gods work in your favor and it works out for you to get a refund rather than owing money. However, in many cases, getting a tax refund from the government can cost you more than adjusting your tax withholdings so that you don't get a refund. Here's why getting money back may not necessarily be in your best interest.
The Truth About Receiving a Tax Refund
If you’re getting a tax refund, that means you’ve been overpaying your taxes, which means you’re giving the government a zero-interest loan.
Most people don't realize this because they're simply happy to be getting income, but in reality, you could be pocketing that money during the year instead.
Letting the government hold onto your money can be a bad idea, and it’s especially dicey for people who carry debt.
If you have debt — such as a student loan, a car payment, a credit card balance, or even a mortgage — you’re paying interest on that debt. But you’re simultaneously giving Uncle Sam an interest-free loan.
So how much is this really costing you? Let’s look at a hypothetical scenario.
Applying Your Tax Refund: Two Scenarios
Scenario #1: One year, Sally gets a tax refund of $3,000. This means she over-paid her taxes by $250 per month. She adjusts her tax withholding so that this will no longer happen.
Sally now receives an extra $250 per month in her paycheck.
One year later, Sally takes out a $15,000 car loan at an 8 percent interest rate. Her payments are $304 per month for 60 months.
Sally applies her extra $250 per month towards her car loan, making a total monthly payment of $554.
Keep Sally’s story in the back of your mind. Now, let’s imagine a second scenario:
Scenario #2: One year, John takes out a $15,000 car loan at an 8 percent interest rate. His payments are $304 per month for 60 months — identical to Sally’s loan.
One year later, John receives a tax refund of $3,000 and uses the entire refund to make an extra payment towards his car loan.
John makes an extra $3,000 payment towards his car every year.
Who saves more money, Sally or John?
Using Your Tax Refund Toward Your Debt Doesn't Save You Money
Sally shaves $1,652 off her interest payments. Plus, her car will be paid off within 30 months, instead of 60 months.
John shaves only $1,342 off his interest payments. His car gets paid off after 36 months.
In other words: John loses $300 and spends an extra 6 months paying off his car, compared to Sally.
Sally cuts the length of her loan in half by applying an extra $250 per month towards her car loan instead of over-paying her taxes.
John loses $300 by giving the government an interest-free loan while simultaneously paying interest on his debt.
Stop Over-Paying Your Taxes
If you want to stop over-paying your taxes, here are a few tips:
- Talk to a professional tax advisor to find out how to get fewer dollars taken out of your paycheck up front. Your tax advisor will create a plan that’s customized to your situation.
- Calculate the difference in your take-home pay after you adjust your tax withholdings. For example, you used to bring home $1,500 per paycheck, and now you bring home $1,600 per paycheck. This means you bring home an extra $100 per paycheck.
- Set up an automatic transfer of that amount — in this example, $100 — into a savings account. Use it to bolster your emergency fund, or use it to pay off debt.
It's important to note that this plan works best if you set up a weekly or monthly automatic transfer for the "extra" money in your paycheck. If you end up wasting that money on trinkets, you won't be any closer to repaying debt.