One of the things that really gets people excited is the thought of a tax refund. According to CNN Money, the average tax refund last year was $3,003. That’s not a bad chunk of change. And when you get a big chunk of change, the possibilities seem limitless. Your tax refund seems like found money. The only problem is that it’s not actually found money. For the most part, it’s your money — money that you’ve been loaning, interest-free, to the government.
Getting Your Money Throughout the Year
In the world of personal finance, you often hear that getting a tax refund is actually a bad thing. After all, what could you be doing with that money throughout the year? If you divide the $3,003 by 12, you realize that you could have $250.25 more each month.
For those who find themselves on a tight budget, having that extra $250 could be a real help. That could mean more breathing room on the groceries, a little extra that could be put toward debt reduction each month, or money that could be saved or invested. For example, getting money a year earlier, invested at a 3.5% annual return, could mean $3,108.11, according to compound interest calculators. That’s an extra $100. Take a little more risk, using P2P lending to invest in monthly notes with an 8% return, and you could end up with $3,243.24 — almost $250 extra! And that’s after one year. If you leave your money working for you after the year is up, the cumulative effect over the years could be quite dramatic.
Of course, the above scenario doesn’t take into account the effect of “extras” like the EIC or the additional child tax credit. These are credits that can boost your refund, regardless of your withholding. However, if you are eligible for such credits, and you have been getting a refund, you can reduce your withholding and still see a boost to your paycheck. This can be a way to improve your cash flow each month.
Getting Your Money All at Once
As tempting as seeing increases to one’s monthly take home pay might seem, this isn’t always the best option for everyone. For some, the psychological impact of receiving a lump sum is greater than seeing a smaller monthly addition to income. It’s one of the reasons that almost no one recognized the Making Work Pay Tax Credit. Instead offering $400 outright, the credit spread it out over the course of a year, and many people didn’t even register that it was there. The same thing is likely to happen with the changes to the payroll tax this year. You become acclimated to the slightly higher paycheck, and no longer notice — or plan for — the “extra” you have. (Of course, once such automatic tax breaks expire, you are likely to notice your smaller paycheck!)
For some, it’s more about having a lump sum to make a grand gesture. Paying for new carpet, taking a vacation, or demolishing debt in one fell swoop can be more satisfying than chipping away at these items month by month. Additionally, I have been told that it’s a more effective savings tool. Sure, you don’t earn interest when you get a tax refund, but a bigger withholding comes out of the paycheck automatically, and then you can’t access to it until refund time, so you cannot raid your savings account when you want a little extra.
What you decide, of course, is up to you, and influenced by what works best in your individual situation. What do you prefer? Do you prefer a big tax refund? Or do you want to use that money throughout the year?