(This is the fourth in a series of blog posts on Personal Finance Fallacies. Stay tuned for at least one more post in the series, released next Wednesday at 9:00 AM MDT.)
Alright, I admit it: I probably exaggerated this myth a little bit. I think that deep down, most people know that a tax refund is NOT a "bonus" from the government.
But a lot of people sure treat it like one!
The purpose of this blog post is to remind you that a tax refund is just your own money being paid back to you, because you had paid too much!
I'll back up a bit and discuss taxes from a very high level.
When you first start a job, you fill out a W-4, which tells your employer how much it should withhold from your paycheck for taxes. As time goes on, you receive a paycheck with taxes taken out already. After a calendar year is complete, you receive a W-2 from your employer, which shows how much you earned during the year, and how much your employer had withheld for taxes. When you file your taxes each spring, you and your tax professional (or tax software) calculate the amount of taxes you actually should have paid the government. If your employer withheld too much, you get a tax refund. If your employer withheld too little, you have to pay an additional amount in taxes.
Not too complicated, right?
Most people get a tax refund. Many people get very large tax refund. What's wrong with that, you may ask? A large refund means that your paycheck was much smaller than it could have been!
Do you remember what your last tax refund was? Let's do a quick exercise. Take the amount of your last tax refund and divide it by 12. That's how much you overpaid on your taxes every month. What could you have done with that money?
The average person gets a refund of a little over $3,000. That means the average person's monthly paycheck was $250 too small! I don't know about you, but I would have liked to keep that extra $250/month instead of giving an interest-free loan to Uncle Sam!
When I was in college, I worked at a credit union. You wouldn't believe the size of some of the tax refund checks I processed! Many were nearly $10,000! The sad thing is that many of these people were extremely poor. They could have used that extra $800 or so each month to pay their living expenses, but instead, the money was going to the government, only to be returned in one lump sum every spring.
Many people go through the same cycle year after year. They live paycheck to paycheck, barely squeaking by, or needing to use a credit card to make up the difference, because they have too much money being withheld from their paychecks. Then tax time comes around, they get a large tax refund, and they (hopefully) use it to pay off the credit card debt. But then the cycle starts again.
So what can you do about it?
As I mentioned before, it's the W-4 at your employer that determines how much you have withheld from your paycheck. If you have too much withheld, you can fix it! Talk to your tax professional to find out how many exemptions you should take so that your refund is as small as possible. Then go to HR and change the form! You should be able to change it at any time during the year! I would also recommend that you change it anytime an event in your life changes your number of dependents (such as an adoption or a birth), or if your spouse starts/stops working.
Remember: your tax refund is just your own money that you should have had all along! If you minimize your tax refund, you'll maximize your paychecks!
(Once again, here's a video of "Uncle" Dave Ramsey, this time with an explanation how you can change your W-4 at your employer.)
(If the video doesn't work, click this YouTube link to watch it directly on YouTube.)