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No, Your Tax Refund Isn't Free Money

By Maurie Backman - Jan 20, 2019 at 7:17AM

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Consider your bubble burst.

The IRS recently announced that it will begin accepting tax returns on Jan. 28, which is a good 2.5 months prior to the April 15 filing deadline. If you're among the millions of Americans who are expecting a refund this year, you'll probably be motivated to file your taxes early. After all, the sooner you submit your return, the sooner you can look forward to that much-anticipated cash.

But before you get too excited about getting your tax refund, know that it's not actually a good thing to be owed money from the IRS. Quite the contrary -- the higher your tax refund, the more you potentially put your finances at risk during the year.

It's not a bonus

Many people view tax refunds as extra money -- a bonus payout, if you will. But, in reality, a tax refund isn't free money. Rather, it's your money -- money you earned during the year but didn't collect in your paychecks.

Man flipping through stack of hundred-dollar bills


Why do most tax filers wind up with refunds? Employers are required to withhold taxes during the year, and the amount that gets withheld is based on the number of allowances you claim on your W-4. If you withhold too little tax, you risk owing the IRS money when you file your return, and that's a frightening prospect for many workers. Therefore, the majority of Americans tend to play it safe by having extra tax withheld during the year, thereby winding up with refunds after the fact.

The problem with that is twofold. First, when you withhold too much tax, you essentially give the government an interest-free loan. Secondly, by depriving yourself of that money during the year, you put yourself at an increased risk of racking up credit card debt.

It's estimated that 40% of Americans don't have enough cash in savings to cover a $400 emergency. Let's say you're one of them, and you encounter an unplanned $400 bill during the year. In the absence of having money in the bank or in your paychecks to cover that cost, you might find yourself whipping out a credit card instead, and then carrying a balance that costs you money in accrued interest. But had you been collecting more money in your paychecks, you might have managed to pay that $400 on the spot and avoiding debt.

And that's why you should never think of your tax refund as free money, because it's not. If anything, think of it as money you needlessly gave up access to during the year.

Adjusting your withholding

If you generally get a large refund year after year but struggle financially all the while, then it might pay to adjust your withholding so that you get a higher paycheck month after month. That said, 2018 is the first year in which new withholding tables were implemented, so you might see less of a refund as a result. Therefore, before you rush to change your W-4, see what your refund looks like on your upcoming return. If it's as high as it usually is, or is still substantial, then it pays to make changes so that your employer withholds less tax from your earnings. That way, you'll start seeing a higher paycheck immediately.

Of course, you don't want to make the mistake of blowing that extra money, because if you end up underpaying your taxes, you'll need to be prepared to pay the IRS by the following year's tax deadline. A good bet, therefore, is to take the additional money you start seeing in your paychecks and stick it directly into a savings account. This way, it's there for you if a financial emergency strikes, and you'll have funds to tap if you do end up owing money to the IRS. At the same time, you'll get to earn interest on that money, as opposed to letting the government do so for nothing in return.

It's always nice to look forward to a windfall, but a tax refund shouldn't be considered one. The sooner you realize that, the more empowered you'll be to stop lending the government money for free and start collecting what's rightfully yours.

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