It’s true, receiving a large tax refund can feel like an unexpected bonus. And perhaps in the past you’ve been forced to listen as excited co-workers and friends discussed their refund-financed shopping sprees.
But congratulations! A small refund actually just means that you did not provide the government with a large interest free loan!
If you are employed full time, you filled out IRS tax form W-4 when you were hired. This form determines how much money is withheld from your paycheck each pay period to cover your personal income taxes.
The amount is an estimate, and the difference between the estimate and the amount you actually owe when you file your taxes each year is either returned to you in a refund or owed in an additional tax payment.
If you received a small refund, the estimate was close to the actual amount of taxes you owed for the year. If you received a very large refund, the estimate was significantly different from the actual taxes you owed, and you may want to consider speaking with an HR representative about updating your W-4.
While it is good to get a small refund, you do not want to underestimate the amount of taxes you owe when completing your W-4 because the IRS can penalize you for underpaying your estimated taxes.
“What is important to know,” explains Marcy Musselman, Financial Coach with Foresters Everyday Monday member benefit1, “is that a refund is just the government giving you back your money. A $1,200 refund means that each month you could have had an extra $100 in your paycheck instead. That money could have gone toward paying down debt, increasing retirement saving contributions or just covering monthly bills.”
Additionally, the government does not pay interest on that forced savings. Instead of having the IRS hold on to that money for you, Musselman recommends setting up a direct deposit into a savings account each month. By making your savings automatic you won’t be tempted to spend that money and you will be earning interest throughout the year.