Why Big Tax Refunds Aren't as Bad as the Experts Say
The average tax refund for an American taxpayer for the 2019 tax year was about $2,600. If you’re one of those getting a refund from your latest tax return, you may already have a concrete plan for what you’ll do with the windfall. According to a survey from the National Retail Federation, roughly half of Americans plan to put some of their money into savings, while about one-third will pay down debt.
If big tax refunds have become an annual tradition for you, then you’ve probably heard that you need to change your withholding. That way, say the personal finance experts, you can sock away more money throughout the year into savings and stop giving the government an interest-free loan every year.
However, it may not be that simple. Learn what to consider when you decide on your tax withholding.
Do You Use Your Refunds Proactively or Reactively?
Economics is not the primary driver behind financial well-being, emotion is, says 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 because they tend to lead to suboptimal decisions. Maurer thinks you’re better off if you can “acknowledge them, recognize them, and plan with them in mind,” he says.
For example, if you know you’re more likely to save that big annual refund rather than save small amounts from each paycheck, “then, by all means, keep your withholdings at wherever they need to be,” Maurer says. This decision is best made with a hefty dose of self-awareness.
If you habitually receive a refund, how do you use the money? If you save it by making an IRA or HSA contribution, you’re being proactive. If you’re paying down the debt you’ve accumulated throughout the year, you’re being reactive.
“One of the reasons people like getting a refund is because their spending at the end of the year tends to bloat a little,” says Maurer. “They’re in debt [from the holidays] and need the refund to pay it off.”
A refund is neither found nor free money—this thinking can lead to the formation of not-so-great habits, like spending more than you should or spending it on things that you shouldn’t. If you’re consistently banking on your refund to bail you out of credit card debt, for example, then the habit of going overboard during the holidays is something that needs to be addressed.
How Would You Feel If You Had to Write a Check to the IRS?
The idea of netting more per paycheck by reducing your withholding is an appealing one. However, what happens if you overdo it and wind up owing the government money? If the mere thought of that scenario is already giving you anxiety, then heed your natural reaction. 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.”
If you absolutely hate the idea of having to write Uncle Sam a check every year at tax time, then you shouldn't feel pressured to tweak your withholdings.
Do You Handle Small and Large Windfalls Differently?
If you’re not sure of your track record on this, think about the last time you got a raise. Did your savings or your spending increase? If getting that small bump in salary usually just leads to you spending more money—but big windfalls like bonuses or refunds wind up going toward savings or debt—then you’re better off sticking with the refund than increasing your paycheck.
Financial behaviorist Jacquette M. Timmons explains that we treat small sums of money differently than how 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 a $1000,” she notes. “With large sums, you tend to think more of them, and do more with them.”
The key, if you decide to adjust your withholding to get more in each paycheck, is to simultaneously adjust how much you’re automatically contributing to savings. “You have to implement that plan immediately,” says Timmons. “That’s the key.” Otherwise, you are likely to waste it.
Do You Have Short-Term and Long-Term Financial Goals?
Whether you decide to reduce your withholding or keep the refunds coming, you will be more successful being thoughtful about the money if you’ve actually made a plan for what you want to do with it, says Timmons. “There are similarities between a tax refund and a bonus,” she says. “Unless you are 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.”