Getting a tax refund can be exciting, but it might not always be a good thing. In two common situations, a tax refund might be doing you more harm than good — but tax pros say there’s a way to take control.
Situation 1: You’re struggling to pay monthly bills
A tax refund may seem like free cash, but actually it’s a return of money that most likely leaked from your paycheck every month via too much withholding tax.
Living off of the resulting smaller paychecks all year may not be so bad for some families if the tax refund is relatively small, says Kathleen Kaminski, a certified public accountant and senior manager at Grossman St. Amour in Syracuse, New York. “So they waited till April 15 to get their $1,000 from Uncle Sam. You divide that by 52 paychecks, it's 20 bucks extra in their pocket every week. What can you get for 20 bucks?” she says. “Now, you can do a lot with $1,000. … Granted, I could use 20, 30 bucks a week, but it would really be more powerful to get that in one lump sum.”
But something like $3,000 — closer to the average tax refund, according to IRS statistics — translates to $250 a month. For families struggling to make ends meet, having that extra money every month could be a game-changer in terms of food security, housing and transportation, or keeping up with loan payments and credit card bills. Instead of waiting for a tax refund, “maybe that $250 a month is better to have,” Kaminski says.
Situation 2: You want to grow your money
For many taxpayers, tax refunds are a method of “forced savings,” says Pete McAllister, a certified public accountant and managing partner at McAllister Kittell Reed in Indianapolis. “That big check in the spring is how they fund their vacation or how they fund a major purchase of some sort.”
But tax refunds could come with an opportunity cost: the ability to grow your money by investing it. For example, instead of shoving that $3,000 under the mattress once a year (or spending it), investing $250 a month at a 6% annual rate of return compounded monthly could give a taxpayer an extra $2,400 after five years.
The trick, of course, is to choose investments that suit your needs. Getting a meaningful rate of return is also key. (“Financial institutions are paying such low interest rates on savings accounts,” McAllister notes.) But even more crucial is having the money available to get started and keep going.
How to take control of your tax refund
One often overlooked tax form — the W-4 — has tremendous power over consumers’ daily financial lives, McAllister says. With it, they can change how much tax comes out of their paycheck. And by aligning those withholdings with their estimated tax obligations for the year, many people can get a portion of their tax refunds in every paycheck instead of having to wait until that one time of year — tax time — to get it back.
Many workers fill out a W-4 on the first day at their job and then forget to adjust it when they have kids, buy a house or otherwise change their tax situation. That’s one reason simply filling out a new W-4 can transform a family’s financial life. “The other thing that would be somewhat helpful is if the employee actually consulted their HR department, who should be able to help them in that regard — or a tax or financial advisor that could help them figure that out,” McAllister adds.
But a lot of people just don't bother, Kaminski says. “They just take it as it is and deal with it in the end. And then if they get a huge refund, then maybe they bring it to their attention. And if they owe money, that's when people really start to get ticked off and try to address it.”