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Thursday, March 13, 2014

3 reasons why your yearly tax refund could hurt you

By Ryan Delacroix

Individual income tax tips
Uncollected tax refunds are wasted money
You’re probably quite excited every year when you get your tax refund in the mail or see it directly deposited into your bank account. You might have had plans for it for months or this might be the money you need to cover a large expense. However, there are solid reasons for making adjustments so that you don’t receive a large refund every year.

1. Your refund was always yours

The most important thing to remember is that the money you receive from a tax refund was always yours. It is money that you overpaid in taxes to the government; it is simply being returned to you. Therefore, if you get a tax refund it means you have given the government an interest-free loan. Have you ever gotten an interest-free loan from a bank? Probably not.

The solution is to have less money withheld from each paycheck. Talk to your employer to fill out a new W-4. If you have less money withheld, each paycheck will be a little larger. If you need the money to cover living expenses, you should definitely use it for that purpose. If not, put the money into an emergency savings fund that earns interest. This certainly beats giving interest-free loans to the government and puts you in a better position should any unexpected expenses occur. After all, emergencies don’t always wait for tax refund time to arise. If you already have a solid emergency fund, contribute more of your income to your retirement account. These generally earn compound interest, so a little extra money invested now can become a lot of money a few years down the road.

2. How much do you really owe?

So, how do you figure out how much tax you will owe? Know what federal tax bracket and what state tax bracket you fit. Do the math to figure out your total income tax, Medicare tax, Social Security tax, and any other tax you expect to owe for the year. Aim to have just enough withheld each pay period to meet these obligations. If you do freelance work on the side, you will have to report that income, so do have a little extra withheld from your day job in that situation.

3. Make your refund count

If you insist on getting a tax refund every year, make sure you use it wisely. If you have outstanding credit card debt, use your refund to pay it down. If your emergency fund is too small or you don’t have one, use it for this purpose. If you need to start saving for your children’s college, use it for that. Do not spend your refund on anything frivolous unless everything else is taken care of.

Finally, do not get a refund anticipation loan or rapid refund. Many tax services offer such financial products—mostly rapid refunds these days since refund anticipation loans have effectively been outlawed. These involve paying a fee to your tax preparation service to receive your refund before the U.S. Treasury Department gives it to you. No matter what it is called, it still amounts to borrowing your own money. If you can't wait a couple weeks to have your refund directly deposited into your account, you should take a close look at how you are managing your money in the first place.

About the author: Ryan Delacroix is a finance blogger and proud Texas resident. He can frequently be found writing about money-saving logistics services in his native Houston, Texas and enjoys helping his online audience navigate the yearly tax season.

Image license: Images Money, CC BY 2.0