You are definitely in good company if you receive your tax refund this year. Every year, millions of taxpayers get a lot of money from the IRS as soon as they file their returns. But while you might be celebrating the idea of a big refund in your bank account, that's not really a good thing.
Tax refunds are not free money.
There is a big misconception that tax refunds are free money. They are not. Conversely, getting a tax refund means you paid more tax to the IRS than you should have last year, and now you get a refund.
What makes matters worse is that if you pay the IRS a lot more yearly and get a big refund, you won't be entitled to interest on that money. In other words, if you get a $5,000 tax refund this year, you gave the government an interest-free loan of $5,000 last year.
But that's not the only challenge with getting a big refund. By not accumulating more of your money as you've earned it, you may have put yourself in a position where you have been forced into expensive debt.
Let's say you ran out of $1000 last year when a big bill came in, so you put it on a credit card and have been paying it off since while accruing interest on it. If you hadn't paid so much extra tax, you might have had enough money on your paycheck to come up with that extra $1000 when you needed it.
You shouldn't get too excited about a big tax refund. You need to make changes to your tax withholding so that your paycheck starts to increase in the future.
How to get less tax withheld from your paycheck
If you are an employee, your employer will use the information you enter on your Form W-4 to determine the amount of tax to withhold from your income, but you can change this information to have more or less tax withheld.
Let's say you get a $3,000 refund this year. If so, and your income is similar this year to 2021, you should probably file a new W-4 and claim more allowance. The more you claim, the less tax will be withheld from your income. This does not mean that your paychecks will automatically increase by $250 per month, but they should increase somewhat.
Don't miss out on money that is yours.
Many people are struggling with rising living costs due to inflation. Suppose you normally get a large tax refund and your income situation hasn't changed much from previous tax years. In that case, it might be worth collecting more income at the start of this year instead of waiting. It can provide you with more financial freedom and prevent you from borrowing too much money from the government for nothing in return.
How do I know if my refund is too high?
As of the end of February, the average refund for fiscal 2021 is $3,536, or $700 more than last year's average refund, according to reports by CNBC. That implies that the average taxpayer who gets paid twice a month could have earned over $147 more per paycheck if their employer had withheld the correct amount of money to remit to the IRS.
If your tax refund is too large, you can reduce your withholding tax to reduce the amount of your refund. The less money you withhold, the more money you will receive for each check, and the lower your tax refund will be.
Remember that if you reduce your withholding tax too much, you will end the year with an outstanding balance, and the IRS will issue you a tax bill when you file your returns.
How can I adjust my Withholding?
Your employer takes estimated tax payments from your paycheck and sends them to the IRS on your behalf. These deductions are based on your filing status, income, and withholding allowances. But in 2020, the Internal Revenue Service completely revamped the process, eliminating allowance numbers and redesigning the W-4 form, which you must submit to your employer to change your withholdings.
To get started, collect your pay statement, information about any other income you earn, and your most recent tax return, and use the IRS Tax Withholding Estimator Tool to guide you through the process.
Also, you should consider using the tool if you change your life circumstances, such as getting married, having a child, changing jobs for your spouse, or finding a second job. And if you discover you're still getting a bigger refund than you'd like, or you end up paying the IRS when you file, talk to a tax professional before you change your Withholding again.
So what can you do with the additional money you get every paycheck? Many people do the same with their tax refunds, like paying off debt, saving, or investing. You can even take these big vacations if you want. The difference is you can do it sooner because you don't have to wait for the Internal Revenue to process your return and send you your refund, and hopefully, you have some extra money from the interest you have earned.
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