Are you expecting a big refund when you file your taxes this year? Most Americans are. In fact, one Credit Karma survey found 62% of people are expecting a refund.
If you're getting a refund, it's probably going to be worth thousands. In 2017, the average refund was $2,763, and more than 97 million people received an estimated $268.3 billion in refunds from the IRS.
Many people look upon this refund as a windfall, using it to do things like pay debt or increase savings. While it's definitely smart to do something responsible with your tax refund, the most financially sound decision would be to get no refund at all.
Why you don't want a refund
The refund check you get from the IRS isn't a windfall, even if it might feel like it. It's your own money coming back that you lent to the IRS interest free -- and you incurred an opportunity cost for making that loan.
There are a lot of reasons it makes more sense for you to not get a refund, but instead to adjust your withholding so the IRS takes only the taxes that are due and your paycheck each month is bigger. Here are a few of those reasons:
- You're tying up your cash: By overpaying around $230 monthly, you lose the opportunity to save the cash during the year. If you paid the appropriate tax, got bigger paychecks, and put $230 into an emergency fund, it'd take less than five months to save over $1,000. If your car breaks down in May, instead of waiting almost a year to get the extra $1,000 you've overpaid the IRS, it would be nice to have the money in your emergency fund to pay those repair bills.
- You're incurring an opportunity cost: By giving the IRS a loan, you lose the opportunity to do other things with the money. Say you owe $5,000 on a credit card at 15% interest and are paying $100 monthly. If you add $230 monthly to your payments, your balance after 12 months would be $1,559 If you had instead kept paying $100 and used your $2,763 refund to make a lump sum payment, your balance would be $1,754 -- $195 more.
- You're paying with money worth more: If you send the IRS an extra $230 in January and they send it back to you in April, the $230 won't buy as much thanks to inflation. In fact, if you overpaid the IRS in January 2016, they'd have had to send you back $237 in April 2017 for you to buy as much as you could've if you hadn't made an interest-free loan to the IRS.
How to avoid getting a refund
The best way to make sure you don't loan the IRS your hard-earned money is to adjust your withholding information with your employer.
You'll probably have to do that anyway thanks to tax reform, so just make sure you aren't having more money withheld than the taxes you'll actually have to pay. You can do that by using a withholding calculator to figure out how much should be withheld to pay the taxes you'll owe.
While you don't want to underpay and get hit with penalties, you should be able to make a pretty close estimate of what you'll owe and can fill out your W-4 form with your employer accordingly.
Then, use that extra money in your paycheck wisely to pay down debt, save, or invest for your future, thereby proving once and for all that you can make better use of it than the IRS.