Getting a big fat tax refund check seems like a great thing. You’ve given the government an interest-free loan and now you get your money back! But having to get a refund usually means you’ve overpaid your taxes throughout the year. Here are some reasons why getting a large tax refund isn’t good and what you can do about it.
You’ve given the government an interest-free loan
When you get a tax refund, it means you’ve overpaid your taxes throughout the year. That money sits with the government, instead of in your pocket, where you could be earning interest on it or investing it. The government gets to hold and use your money, interest-free, while you wait for your refund.
Let’s say you get a $2,000 tax refund. If you had that extra $2,000 throughout the year and earned 5% interest, you would have made $100 in interest. That’s $100 you’ve missed out on because you gave the government a loan.
You could have invested the money
Instead of letting the government hold your money, you could have invested it yourself. That $2,000 refund could have been invested in stocks, bonds, mutual funds, and other assets that generate returns. Over decades of investing, the power of compounding builds wealth.
For example, investing $2,000 and earning a 7% average annual return would grow to over $7,600 in 20 years. Instead of having that money, your $2,000 tax refund is gone as soon as you spend it.
You lose out on Tax-Advantaged Accounts
Getting a large refund means you likely didn’t optimize using tax-advantaged accounts like 401(k)s, IRAs, HSAs, etc. Contributing pre-tax money to these accounts reduces your taxable income, so you get immediate tax savings. Under-utilizing them means missing out on that tax benefit.
Most people don’t go back and max out these accounts later. That tax refund is usually spent and gone forever. So you’ve permanently missed out on tax savings and the growth potential in accounts like 401(k)s and IRAs.
You can adjust your withholding
If you usually get a large tax refund, the #1 thing to do is examine your federal and state income tax withholding. Adjust your W-4 with your employer so less tax is withheld from each paycheck. Going forward, more money will stay in your paychecks instead of going to Uncle Sam.
The IRS Withholding Calculator can help determine the right withholding. Your goal should be to break even at tax time, not get a big refund. Then you keep more money throughout the year when you need it.
Other ways to decrease your refund
In addition to adjusting withholding, here are some other tips to reduce your tax refund amount:
- Contribute more pre-tax dollars to workplace benefits like 401(k), HSA, FSA
- Increase deductions using methods like bunching charitable contributions
- Harvest tax losses by selling investments at a loss to offset capital gains
- Split income and maximize tax brackets if married filing jointly
- Contribute to an IRA if income allows and you don’t have a workplace plan
The goal is to lower your taxable income and minimize how much tax is withheld from each paycheck. Done right, you keep more money now instead of waiting on a refund.
What to do if you’re used to a big refund
For some families, over-withholding taxes and banking on a large refund is a forced savings strategy. They know they won’t voluntarily save money each month but can spend a lump sum refund wisely. They also may fear under-withholding and facing a large tax bill.
If this fits you, develop a system to replicate refund-forced savings. Examples include:
- Set up automatic bank transfers to a savings account each payday
- Enroll in employer-sponsored savings plans like 401(k)s
- Pay down debts with the extra per-paycheck cash flow
- Invest via automatic contributions to IRAs and taxable accounts
This takes discipline but replicates forced savings you’re used to. As you get used to saving regularly, you can then adjust withholding to maximize cash flow without the refund.
When is a refund okay?
There are certain situations where it’s okay or even smart to get a tax refund:
- Your income varies significantly year-to-year making withholding tricky
- You have difficulty saving regularly and need a forced refund savings plan
- You are risk averse and the peace of mind is worth it
- You don’t want to owe taxes and get hit with penalties
It’s also your only option if making estimated tax payments, since wage withholding isn’t involved. If this fits you, at least make sure to submit Form W-4V to the IRS for any refund over $500. This voluntarily withholds extra tax to get a refund instead of owing.
Use the myRA program
myRA is a Treasury Department program that allows you to direct your tax refund to a retirement savings account. You specify the refund amount to contribute and it gets invested in a low-risk government bond fund. It’s a great way to force yourself to save your refund.
Table Summary
Reason | Why a Tax Refund is Bad |
---|---|
Interest-free loan to government | Government holds and uses your money while you miss out on interest income |
Missed investment returns | Refund money could have been invested and compounded over time |
Lost tax benefits | May miss out on optimizing tax-advantaged accounts like 401(k)s |
Conclusion
Getting a big tax refund might feel great in the moment, but it often means you’ve loaned money to the IRS at 0% interest all year. Rather than seeing a refund as “extra” money, adjust your thinking so you view it as your hard-earned money. Then make adjustments to ensure you get your full paycheck throughout the year.
Start by examining your withholding and making changes to get the most accurate amount withheld from your paycheck. Use tools provided by the IRS to calculate the optimal withholding. Then look for other ways to reduce your taxable income and keep more cash flow upfront.
Break the psychology of banking on a refund. Learn to regularly save and invest the extra money from each paycheck. Your future self will thank you.