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?
{ read the comments below or add one }
I have always loved our tax refunds. For several years we used the $$- approx 2-3K for a vacation. Now that we are about to have our first child the $$ will be used for daycare. Our refund should be over 4K next year- add that to the 5K we set aside in an FSA and we are almost covered for the year in daycare. I know some say it’s best to add it to the paycheck month by month but this system works well for us. We look forward to the large lump sum check.
Adjust withholding so you get it throughout the year… it’s not so much about earning interest but being able to properly plan your budget without a huge windfall each year.
I kind of think people will take the bigger refund come tax time instead of running the risk of being under-taxed during the year and owing money to the government because of it.
I would rather have a larger tax refund than getting the money throughout the year. I could be allocating that money towards a goal. This year I’m expecting about $1,000 and plan on putting that towards my debt.
I try to set up my withholding so that I get most of it back in my paychecks. However, I do have my 9-5 job’s payroll filed to withhold with one fewer exemptions then I could. I pull in 1-2k/year in freelance income (just the occasional side job), so it’s easier to have my daytime employer withhold a little extra so that I don’t have to worry about quarterly payments.
Still, I aim to owe or be owed ~$100 or less at the end of the year.
When it’s in my paycheck, I use it responsibly. When it’s a lump sum, I’m more likely to use a large chunk of it frivolously.
I prefer to have it come out even, or if not, to owe the IRS and the State.
I prefer to have less at the end of the year and more during it, so I used 3 on the W-4 exemptions when I was single with no dependents and still got a refund of around $1k per year. I wanted some safety net though, just in case, so I didn’t put it higher. I also own a condo and the property taxes are much easier to pay when I have that refund come in. I have a child now, but I can’t claim him for this first year because apparently he didn’t live with me for at least half a year (he was born in September), so it will be interesting to see how it affects my taxes next year…I might have to claim even more exemptions.
Er, if he was born in September you should be able to claim him…
Sorry, I forgot the second problem I ran into. I figured I should be able to, so I chose the option that I have a qualifying dependent, but then it didn’t let me claim him because I am not 24, although I turned 24 last year (so maybe it’s counting age at the beginning of the year?). It’s still odd…maybe I am missing something?
KM, I would talk to an accountant or call the IRS. I know many people who have tried their hardest to have their baby’s born on the right side of Jan 1 so as to be able to claim them (and not be hit with a double deductible) – as long as the baby is born in a calendar year, you can claim him or her for that year.
Are you being claimed as a dependent on your parent’s taxes or anything like that? My oldest son was born when his father and I were both under 24 and we never ran into any difficulty claiming him.
Of course, there could be something about your situation that is different, but I’d urge you to check and make sure.
um, make that babies.
No, I haven’t been claimed as a dependent for years. I tried looking up information on this, and I found that he should qualify, but there was nothing about the 24 years anywhere except that it’s used as a cutoff for using children in college as dependents. So I think I will just check the program again and call IRS to see what I can do. Thanks for the advice.
Oh by the way, I think it’s really odd to try to schedule a baby’s birth on a certain day just to take advantage of the taxes. I know taxes are a ripoff these days, but that’s just strange to me.
While I fully realize that having too much deducted from my pay during the year is the same as loaning money to the gov without getting interest for it, I still like getting a lump sum refund. The few dollars a month add up to a new set of tires for my truck or some other major expense that I wind up not saving for the rest of the year. This year, depending on what I get back, I’ll be buying some solar panels and wind turbine alternative power equipment to offset my grid connected power. Last year, I paid for part of my daughter’s wedding with the money.
I think it’s important to have a set goal in mind for the refund amount. I don’t “do” shopping, which means I won’t be spending it on frivolities.
I think it’s just easier to plan when you take the proper exemptions and don’t overpay. There’s too much temptation to spend the tax refund if you get a sizable one (last year the average was $3,000+).
In the past, we’ve always received a nice sized refund because my husband receives a bonus each year that is taxed at the highest rate. It’s difficult to fiddle with the exemptions because the bonus is not guaranteed and as much as we’d like an extra couple hundred bucks a month, we’d really hate having a bill for a few thousand if that bonus didn’t happen.
I do agree with Money Beagle that with interests rates so low, it makes sense to make the choice based on your own spending and saving personality, unless you have debt at a high interest rate that you could be paying off.
I think that the temptation to spend it throughout the year is too great for many people, so they lose the benefit of being able to earn interest on it. Now that interest rates are next to nothing, this is more evident than ever.
The best way to offset this would be to increase your exemptions, but instead of having your paycheck get bigger, have an automatic direct deposit in that amount to some sort of savings account. That way you don’t see the money and the temptation isn’t there to spend it.
Again, with interest rates as negligible as they are, I question the worthiness of spending time on this.
The interests definitely doesn’t seem to justify spending time on this, so it really boils down to whether you are a person that would spend more if you get a lump sum (refund) or if you would spend more if your paycheck got a little bigger.
I don’t think there’s a right answer to which method makes more sense if more savings is the primary goal, as there are a sizable group on both ends of this.
I agree. “Know thyself” looms pretty large here, so it’s a really individual choice how you want to go.