Why I Don’t Want a Huge Tax Refund and Neither Should You!
It’s officially tax season and as we prepare to file our taxes, most of us are anticipating receiving a refund. But before you throw confetti and get excited about a nice check, it might interest you to know a big refund isn’t always the best strategy.
Safe Harbor Rule
As W2 employee, a certain percentage of taxes is withheld from your paycheck. Aside from any tax credits, most people withhold more than what they owe in total tax during the year, which is why they’re due a refund during tax season. You overpaid your taxes, and then you get that money back. Did you know it’s possible to receive a larger paycheck throughout the year by adjusting your tax withholding? It’s true. But first, how do you know what you should be paying without owing a penalty for under withholding? The answer is in the Safe Harbor Rule:
- If you expect to owe less than $1,000 after tax withholdings and credits, you’re safe.
- If you pay at least 90% of the tax you owe for the current year, or 100% of the tax owed for the previous year, you’re safe.
- If the adjusted gross income on your previous year’s return is over $150,000 (over $75,000 if married filing separately), you must pay the lower 90% of the tax shown on your current year’s return or 110% of the tax shown on the previous year’s return.
How to Adjust Your Withholding
It’s best to consider making an adjustment to your tax withholding if you receive a large income tax refund. Try using the IRS’s withholding calculator to determine the proper withholding. Once you figure out what your withholding should be, you can file a new W-4 with your employer and wait for your next paycheck to reflect your changes. You can use an online paycheck calculator so that you can simulate what your paycheck will look like if you were to make the changes.
Why You Don’t Want a Big Tax Refund
The simple reason you don’t want such a large refund is because you can be rerouting those funds during the year and put them to better use. Here’s how:
- You could be using the extra cash to pay off negative balances like credit card debt or student loan debt.
- You could be adding to your savings, therefore being better prepared for any type of emergency that can occur during the year.
- You could be investing in your IRA – giving you more time in the market and allowing you to earn interest – helping you be better off in the long run.
- You could bump up your 401(k) contributions benefiting you in the same way as mentioned above (IRA).
Something to Consider
Money in your pocket during the year being a better option than a bigger refund is only true if you exhibit good money habits. If receiving extra cash from your paycheck means you’ll make poor choices, perhaps you’re better off leaving your tax withholdings just as is. After all, a “forced savings” option (like a refund) is better than having no savings at all. Or maybe you like your refund because it helps you pay off debts that get billed a couple times a year. Perhaps you would like to use it for your yearly vacation. Whatever your reasons may be, it’s important to be strategic. So, analyze what works best for you and consult with your tax advisor or financial planner to make a plan that is best suited for your individual situation.
In this episode, Luis talks about the following and more:
- How to avoid paying a penalty for under withholding
- Adjusting your withholdings to increase your take home pay
- The benefits of pre-tax savings
- Opportunities to take advantage of with the increased cash flow