Most taxpayers are used to getting a refund when they file their returns, and while refunds have thus far been smaller for the 2018 tax year than in years past, we can still expect a large number of workers to get money back from the IRS this season. And the good news is that most folks plan to use that money responsibly. In fact, 31% of Americans who get refunds plan to pay off existing debt with that cash, according to a new survey from Offers.com. Other folks, meanwhile, think they'll use their refunds to build savings, cover regular expenses, travel, splurge, or invest. But in the aforementioned survey, tackling debt is the most popular response among those expecting a payout after filing their tax returns.
Here's the thing, though: Chances are, for some of these folks, overpaying taxes during the year is the reason they landed in debt in the first place. If you're planning to use your tax refund to tackle your debt, think about whether that lump sum is actually to blame for your current predicament.
Tax refunds aren't a good thing
Many of us are wired to think that tax refunds are something to celebrate. After all, that's free money back from the IRS, right?
Wrong. When you get a tax refund, it means your employer took out too much tax from your earnings month after month, thereby letting the government keep it longer while you got nothing in return. Of course, employers don't overtax employees on purpose. Rather, they follow IRS-issued withholding tables that dictate how much tax to set aside based on factors that include earnings and allowances claimed by workers on their W-4 forms.
The problem, however, is that the current withholding system is an imperfect one, so much so that it's virtually impossible for earners to pay the precise amount of tax they should be paying so that come tax time, they break exactly even. That's why tax refunds are so common -- because workers tend to err on the side of overpaying their taxes rather than do the opposite -- pay too little and risk owing the IRS money. But in overpaying taxes, workers risk racking up debt when they need extra money to cover expenses and that cash isn't made available in their paychecks. And that's why the average American shouldn't actually be getting a tax refund year after year -- because most folks live paycheck to paycheck and can't afford to wait on that money.
Let's assume you're getting a $2,000 refund this year, and that you plan to use it to pay off $2,000 in debt that you racked up in 2018. Well, it's likely that at least part of that debt stemmed from the fact that you didn't get your money up front in the first place, but rather, let the IRS hang onto it for months.
A better bet going forward, therefore, is to adjust your withholding so that you're not having as much tax taken out of your earnings. This especially holds true if you wind up getting roughly the same refund amount on your 2018 taxes as you've gotten in the past.
Now if you're worried that withholding less tax will put you at risk of owing the IRS money next tax season, the truth is that that's a valid concern. But here's how to alleviate it: Rather than spend the extra money that comes through in your paychecks once you make those adjustments, put all of it in the bank. If, during the year, you encounter unplanned bills you can't cover, you can dip into that savings account to avoid racking up debt. Otherwise, leave that money alone and see what your taxes look like come this time next year. If you do indeed owe money, you can use the cash in that savings account to cover your tax bill without having to worry about accruing interest and penalties for being unable to pay it. And that way, you'll have earned interest on that money, instead of giving the government an interest-free loan.
If you're getting a tax refund this year, the best thing you can do is use it responsibly. At the same time, think about whether that missing money was the cause of financial stress for you during the year, and take steps to get your hands on more of your income as you earn it.