On Jan. 1, 2018, Congress enacted the largest piece of tax reform legislation in decades. The new law considerably increased the standard deduction, and lowered the tax rates on the middle class, and the effects of these changes are finally being felt by taxpayers as they file their 2018 taxes.
Tax refunds are up 0.7% from last year, according to the latest data from the Internal Revenue Service (IRS). So far, the average tax return this year is $3,068, compared to $3,046 last year. This may seem like cause for celebration, but there's a glaring drawback to larger tax refunds that most people overlook.
The problem with large tax refunds
The government collects taxes from every paycheck throughout the year (unless you're self-employed, in which case you must set aside tax money on your own through quarterly estimated tax payments). Then, when you file your taxes, if the IRS collected more than it was entitled to take from you, the government returns the extra to you in the form of a tax refund.
The effect is that you wait months to use money that was yours to begin with. You're essentially giving the government a free loan, because it doesn't even pay you any interest when it returns your money every tax season.
If the government withheld a smaller amount from each paycheck, you would end up with a smaller tax refund, but in exchange, you would have more money every month to put toward living expenses, debt payments, savings, spending on things you enjoy or investing. If you invested some of that money, it could grow exponentially over time, whereas there's no hope of putting that money to work when it's in the government's hands.
How to keep more of each paycheck
The government uses your withholding status to determine how much money to take from each of your paychecks. When you started your job, you indicated how many allowances you wished to claim on your Form W-4. If you're not sure how many allowances you're currently claiming, check with your company's HR department or the person who handles taxes for your employer.
Adults without children usually claim one or two allowances, and this number rises as your household grows. The more allowances you claim, the less money the government will take from each paycheck. But this may also reduce the size of your refund check, because the amount you pay in throughout the year will be closer to your actual tax liability. You don't want to claim too many allowances, though, or else you might end up owing taxes at the end of the year if the government didn't collect enough from your paychecks throughout the year.
If you're unsure how many allowances you should be claiming, fill out the Form W-4 worksheet or use the IRS's Withholding Calculator. You may need to update your tax withholding as your lifestyle changes. If you get married or have kids, you'll probably claim more allowances, and then as your kids grow up and leave the house, you should reduce your allowances again. You must fill out a new Form W-4 and submit it to your employer in order to change your tax withholding.
A large tax refund can be a good thing, but a larger paycheck every pay period is even better. Once you've gotten your 2018 tax refund, take a look at it and decide whether you need to adjust your tax withholding. If you're getting thousands of dollars back, that may be an indication that you should claim more allowances next time around.