Breathe, folks! Tax Day has come and gone for yet another year.
Tax time is, for most Americans, a bit of a bittersweet moment. On one hand it requires taxpayers to meander through numerous receipts, W-2s, and other financial records. All the while, taxpayers have to conform to what amounts to more than 10 million words of the U.S. tax code. In other words, preparing your taxes can be exceptionally complicated – just in case the more than 100 pages of explanations on how to fill out the most basic tax form, Form 1040, didn't give it away.
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Yet, for a vast majority of taxpayers, tax season is like a holiday in that it often means a fat refund check from the federal government. Since the U.S. economy is so reliant on consumption, retailers count on these refund checks to drive discretionary purchases. When not shopping to their heart's desire, taxpayers are using their refunds to pay down debt, supplement an emergency savings account, or pad their retirement nest egg.
4 in 5 taxpayers gave the government a $2,851 interest-free loan in 2016
Yet, herein lies a pretty serious misconception. Though it might be nice to receive money instead of owe money around Tax Day, getting a large refund from the federal government is almost always a bad sign, suggesting that you managed your money poorly during the previous year.
According to tax filing statistics from the Internal Revenue Service through April 7, 2017, 103.6 million returns had been received, of which 101 million had been processed. Notably, 80.3 million of those processed returns (80%) received a federal refund averaging $2,851. On an apples-to-apples basis, that's up nearly 2% year over year.
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The problem is that this average refund of $2,851 heading back to taxpayers has been sitting in the hands of the federal government for months, or even upwards of a year, and it doesn't earn a red cent in interest for taxpayers while in the government's hands. This means that as long as inflation is positive, taxpayers' purchasing power and financial flexibility were reduced due to their income tax overpayment throughout the year.
Adjusting your federal tax withholding is a smart move to consider
Some of you might rightly be thinking that getting a large tax refund the following year is really no different than getting a paycheck boost throughout the year. For those taxpayers who have an exceptionally hard time saving money, the federal-refund route might be a decent idea because it'll force them to save and keep them from impulse buying.
But for a majority of taxpayers, it's a far smarter idea to adjust their federal tax withholding in order to boost their take-home pay. The reason is simple: it's your money and you'll have more flexibility with what can be done with it now rather than later. Getting a bigger paycheck now means being able to invest it immediately, whereas you may have to wait a year or longer to begin earning interest on your earned income if you're getting a federal refund. Getting more with each paycheck could put you that much closer to your retirement goal, especially with the stock market averaging a return of 7% a year, inclusive of dividend reinvestment, over the long run.
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Similarly, getting more money with each paycheck by not overpaying the federal government means having more money to pay down interest-bearing debt, especially credit card debt, which recently crossed $1 trillion in aggregate in the U.S. Waiting for a federal refund the following year means you're giving your debt a year or longer to accrue interest, which isn't optimal. Adjusting your federal tax withholding to have less income taken out of your paychecks could actually help you whittle down your debt faster and result in you paying less in interest.
Best of all, adjusting your federal tax withholding can often be done in about a minute, meaning it's exceptionally easy to get your net owed or refunded amount each year close to $0, which should really be the goal of every taxpayer. Adjusting your withholding can also be done multiple times a year, so you really have the added flexibility to put more money in your pocket right now.
Tax planning isn't a once-a-year event. Take the steps necessary to make sure that you're not among the 80% of taxpayers next year who wound up giving the federal government an interest-free loan on your hard-earned income.
