A big tax refund is an American tradition. But is it a good idea?
Many families like the idea of an annual "windfall" in the form of a refund check. But what they are really doing is allowing Uncle Sam to hold on to an extra amount of their paycheck for as long as a year without paying a dime of interest.
Still, each year millions of American workers have more than they need withheld from their paychecks as a way to get that big refund at tax time. It's also a distinctly American ritual to eagerly wait for the big bucks to arrive sometimes even taking out a short term and costly "refund anticipation loan" to get the money more quickly than the federal government can deliver it.
Financial advisers have long said that taxpayers are better off adjusting their withholding so that they have only what's necessary deducted from their paychecks, rather than giving the federal government more than it needs in the form of an interest-free loan.
I take a bit of a more middle-of-the-road approach. For some people, withholding too much to get a tax refund can be an effective form of forced savings. If you don't get your hands on the money at paycheck time, you can't spend it. The trick, of course, is not to go hog wild and treat your tax refund like a lottery win the following year, using it to buy everything you and your family have been desiring for months.
In times of low savings rates, over-withholding isn't as much of a financial offense as it is when you can earn a decent amount on your cash.
Still, a better option might be to adjust your withholding so that you get less of a tax refund. Have the extra money that will be in your paycheck automatically diverted into a bank account or some other type of savings/investment vehicle. Many banks can set up such an arrangement in minutes.
So how do you adjust your withholding?
Here are some tips from the IRS:
Do it right, from the start • When you start a new job, you'll be asked to fill out an IRS form W-4, short for Employee's Withholding Allowance Certificate. This determines the amount of federal income tax that will be withheld from your paycheck. The IRS has a nifty calculator that can help you figure out the right level of withholding at 1.usa.gov/Nxnvh8. To print a W-4 form, go to irs.gov and click on "W-4" on the left side of the page.
Make changes as needed • You may want to alter your W-4 in the event of a job loss, a home purchase, a divorce or the birth or adoption of a child. Again the calculator can help you determine the right amount.
Take care if you're self-employed • If you don't have an employer to handle your withholding, you must make estimated tax payments throughout the year. Self-employed people can use form 1040-ES, Estimated Tax for Individuals, to find out if they are required to pay estimated tax on a quarterly basis. For more information, go to 1.usa.gov/PRjZub.
Take advantage of online IRS resources • IRS Publication 505, Tax Withholding and Estimated Tax, is a helpful guide to figuring out how much should be withheld from your paycheck, whether you're employed by a company or self-employed. It's available by going to irs.gov and typing in "Publication 505" into the search field.
Going through the process of adjusting your tax withholding is not exactly fun, but it's a basic financial planning tool that over time can boost your financial bottom line.
Lesley Mitchell writes One Cheap Chick in daily blog form at blogs.sltrib.com/cheap.