How Obama benefits from your tax refund

With tax season in full swing, many taxpayers are filing tax returns with high hopes of receiving a fat tax refund in the coming weeks. Individuals who have been pressed for cash see an income tax refund as wiggle room in their budgets.

When expanding the lens to include the big picture, however, it becomes clear that a $1,000 or more refund is not great for your finances after all.

What a Huge Income Tax Refund Means

Getting your money back from the federal government during tax season in one lump sum might seem like a good thing, but in fact, it can be detrimental to your savings account. Why? Simply put, being owed a refund means you’d been overpaying Uncle Sam the entire year.

Still don’t see anything wrong with this concept? Consider the following scenario:

Someone you have no personal connection to (i.e., not family, a friend or significant other) asks to borrow $15,000 from you. You’d likely charge them a percentage of interest in addition to the principal amount borrowed, even if this hypothetical borrower had an outstanding credit history — after all, you’re doing him a favor and would like to balance the risk with some kind of return.

The same scenario plays out when depositing money into a savings account or certificate of deposit account at a bank. Your physical cash never truly stays in a safe with your name on it; rather, banks use your deposit as a temporary loan with the promise to pay it back, plus interest. In the end, the sacrifice you make in parting with your funds temporarily is compensated with interest earnings.

When too much of your wage income is withheld for federal taxes, you’re giving away an interest-free loan to the government without receiving anything extra in return. So when a hefty tax refund is sent your way after you’ve filed your tax return, it’s a sign you’ve been duped.

This realization might leave you with bitter feelings of betrayal, but there is an easy way to ensure that the right amount of your income is withheld from your paychecks moving forward.

Federal Income Tax Withholding Allowances

The amount of income tax that is taken out of your gross pay depends on the information you entered on your W-4 form upon being hired by your employer. According to the IRS’ Publication 505 Tax Withholding, factors that employers use to calculate how much of your pay is taken out for federal income taxes include:

• Marital status (e.g., single, married, married but withhold at higher single rate)
• How many withholding allowances you are eligible for and want to claim (the higher the amount the less is withheld from your pay)
• Any additional amount of your income you want withheld
• If you want to claim an exemption from withholding in the previous year

The tax refund issue arises when taxpayers convince themselves paying more taxes than what is owed is a safe bet against owing money after filing a tax return; for this reason they claim the smallest withholding allowance of one or even zero. However, by accurately filling out your W-4 with the correct number of allowances, you can both pay your due to society via federal income taxes, and help your savings account.

Benefits of Reducing Your Tax Refund

There are many ways reducing your tax refund by adjusting withholding allowances can help grow your savings account and your finances overall. Here are a couple benefits of a smaller refund:

• Ability to earn more money. Instead of giving an interest-free loan to the government, you can allocate the extra take-home cash from your paycheck into an interest-bearing account throughout the whole year. While deposit rates are still low, online banks offer competitive rates that can earn you more with little risk involved.
• Better money management. A common argument against reducing tax refunds is that extra access to cash incrementally throughout the year will just lead to spending it, and not saving it. However, having a more accurate and consistent view of your budget and finances — rather than a sudden flood of income via a big tax refund during tax season, which will likely be blown anyway — leaves you in a better position to refine your money management skills year-round.
• Control. By having access to your money throughout the year, you can use it or save it as you see fit. There is no invisible obstruction keeping you from using money you’ve earned to pay for routine car maintenance, or on nights out with friends. Ultimately, you’re accountable for how your money is used.

A massive tax refund can feel like Christmas Day revisited, but understanding what a large refund really means opens the door to great savings potential in the long term.