Capital Region families: Are you getting a big check back from Uncle Sam this year? If the latter (75% of Americans are), before you celebrate winning lotto, it might interest you to know that a giant refund isn’t cause for celebration.
Why You Don’t Want a Big Tax Refund
The simple reason you don’t want a refund is that getting one means that you’ve just loaned the U.S. government your money—without making interest on the loan. The government has made the interest...and lots of it...at your expense.
It’s not the smartest financial plan, especially if you’re carrying around credit card debt, student loans or a negative balance of any kind. Instead of loaning that money to the government, you could be making that money work for you—and earning interest on it at the same time.
Here’s what you could be doing with your money if you had had it for that year. Let’s assume you had $2,800, the amount of the average refund in 2012.
- You could save for retirement. When you let the government sit on nearly $3,000 for up to 12 months, you’re giving up a huge opportunity for savings. What if, instead of waiting for the I.R.S. to refund you your overpayments each spring, you bumped up your 401(k) contributions by a percentage point or two (or more)? Over several decades of your working career, that change could earn you a more comfortable retirement. There are ups and downs in the market, but if you’re a long-term investor and you don’t put that money in until you get your refund, you’re basically losing a year’s worth of appreciation on it.
- You could have an emergency fund. That $2,800 is no small chunk of change. If you had an unexpected car expense or medical bill, you’d probably be really happy you had it. Emergency funds don’t come out of the sky—you have to put money aside, little by little. If you don’t have one, an extra $233 a month would help start to fill yours out. (Experts recommend you have enough funds to tide you over for six months.)
- You could pay down debt. As mentioned, a refund of $2,800 is an extra $233 a month you could have had in your pocket—which you could have used to pay off debt or to have kept yourself from getting into debt. About half of U.S. households report carrying a credit card balance, an average of $15,000 on three cards. Even if you’re not paying that high of an interest rate on your plastic, the average credit card charges 13% to 15% in interest, so keeping your balance low is a good idea.
How to Fix the Problem
If you’re getting $200 back in April, there’s no need to go rushing to your benefits department to adjust your withholding. But if your refund is closer to $1,000 to $2,000, and especially if the amount is a relatively big percent of your income, you should consider making an adjustment. Your best bet: the IRS’s withholding calculator at www.irs.gov. Once you find out what your withholding should be, you can file a new W-4 with your employer, sit back and wait for your fatter paycheck.
If you do decide to take the high (paying) road, consider putting something in place to keep you from spending your newfound funds. For instance, set up an automatic transfer every payday from your bank account to a mutual fund, retirement or investment account, or to your student loan company. Or go ahead and boost your 401(k) contributions by an equivalent percentage. At retirement, you'll thank your current self.
Come and learn this critical concept, and much more, at Lunch & Learn: De-stressing over Money at Arthur's Market in the Stockade District of Schenectady. Wednesday, February 12. Watch this for details.
Dave Balog teaches financial literacy. firstname.lastname@example.org, 355-0967.