Why Big Tax Refunds Aren't as Bad as the Experts Say

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You may already have a plan for what you'll do with the windfall if you're expecting a tax refund in 2022. More than half of American taxpayers plan to put at least some of the money into savings, while about one-third will pay down debt, according to a survey from the National Retail Federation.

The average American taxpayer received a tax refund of $2,815 in 2021. This increased to $3,305 in March 18, 2022, although final figures for the 2022 filing season won't be available until the end of December.

You've probably heard that you should change your withholding if big tax refunds have become an annual tradition for you. This would increase the size of your paychecks so you could save more money throughout the year without giving the government an interest-free loan. Getting your withholding just right can even mean taking anticipated windfalls from refundable tax credits, such as the Child Tax Credit, into consideration.

But it may not be that simple. Learn what to consider when you decide on your tax withholding.

Key Takeaways

  • The average tax refund is about $3,300, although final statistics aren't yet available for the 2022 filing season.
  • Receiving a large refund means that you had more tax withheld from your paychecks all year than was necessary to cover what you owe. The IRS is simply returning the money to you without interest.
  • Receiving a refund can be a good thing if it prevents you from squandering the money during the year and if you put your refund to a good purpose when you receive it, such as savings or paying down debt.
  • You can adjust your withholding at any time by submitting a new Form W-4 to your employer. The IRS provides a useful tool online that can help you get it right and it includes consideration of any tax credits you think you might be eligible for.

Do You Use Your Refunds Proactively or Reactively?

Emotion, not economics, is the primary driver behind financial wellbeing, according to financial advisor Tim Maurer, author of the book "Simple Money." Some financial advisors will tell you to remove your emotions from your financial decision making. Relying solely on your feelings tends to lead to less-than-perfect choices. Maurer thinks you're better off if you can "acknowledge [your emotions], recognize them, and plan with them in mind."

"By all means, keep your withholdings at wherever they need to be," Maurer says if you know you're more likely to save that big annual refund rather than save small amounts from each paycheck. This decision is best made with a hefty dose of self awareness.

Ask yourself how you use the money if you usually receive a refund. You're being proactive if you save it by making an IRA or HSA contribution. You're being reactive if you pay down the debt you've accumulated throughout the year.

"One of the reasons people like getting a refund is because their spending at the end of the year tends to bloat a little," Maurer says. "They're in debt [from the holidays] and need the refund to pay it off."

A refund is neither found money nor free money. This thinking can lead to not-so-great habits, like spending more than you should or spending it on things that you shouldn't. The habit of going overboard during the holidays is something that needs to be addressed if you're consistently relying on your tax refund to bail you out of credit card debt in the spring.

How Would You Feel If You Had to Write the IRS a Check?

The idea of netting more per paycheck by reducing your withholding is an appealing one. But what happens if you overdo it and end up owing the government money at the end of the year instead? Heed your natural reaction if the mere thought of this scenario makes you break out in a cold sweat.

Maurer says, "How much is someone actually saving in order to placate themselves emotionally? If it works for someone to receive a higher refund, then that's fine."

You shouldn't feel pressured to reduce your withholdings if your goal is to avoid writing Uncle Sam a check every year at tax time.

Do You Handle Small and Large Windfalls Differently?

Think about the last time you got a raise. Did your savings or your spending increase? You're better off sticking with the refund than increasing your paycheck if getting that small bump in salary usually leads to you spending more money, but big windfalls like bonuses or refunds wind up going toward savings or debt.

Financial behaviorist Jacquette M. Timmons explains that we treat small sums of money differently than we treat large ones. "We have a tendency to discount small amounts and not really appreciate how those small amounts accumulate and grow. Even saving $2.74 a day for a year adds up to $1000," Timmons notes. "With large sums, you tend to think more of them and do more with them."

Simultaneously adjust how much you're automatically contributing to savings if you do decide to adjust your withholding to get more in each paycheck. "You have to implement that plan immediately," says Timmons. "That's the key." Otherwise, you're likely to waste the money.

Do You Have Short-Term and Long-Term Financial Goals?

Whether you decide to reduce your withholding or keep the refunds coming, you'll be more successful if you've actually made a plan for what you want to do with the money, says Timmons. "There are similarities between a tax refund and a bonus," Timmons says. "Unless you're intentional and purposeful, already have [a plan] for the money, and—as soon as the money hits your account—you do [implement that plan] right away, you're probably going to waste the money."

Frequently Asked Questions (FAQs)

How do I adjust my withholding?

Your withholding is a way to predict your tax liability for the year in advance. Your employer will require that you fill out Form W-4 when you start a job, and you're free to submit a new one whenever you like if you undergo a major life event that may change your allowances. This tells your employer how much to withhold from your paycheck for taxes. The IRS provides a tax withholding estimator on its website to help you get your withholding as right as possible. You'll be responsible for paying the taxes when you file your return if you don't pay them at the payroll stage.

What's so wrong with receiving a big tax refund?

There's nothing erroneous or wrong about getting a large refund. But it probably means that you overpaid taxes during the year if you do. The IRS is just returning that overpayment to you without interest. You could have used the money toward investments or other money-making efforts if it had been paid out to you as income at the time you earned it rather than withheld at payroll.

Is there a penalty for receiving a large tax refund?

The entire tax-filing process is designed for the IRS to manage income tax overpayments and underpayments. You'll only be penalized for errors and any fraudulent activity in this process if you attempt to game the system or avoid paying taxes altogether.

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