From a psychological standpoint, a tax refund feels like a windfall. It’s cash in your bank account that wasn’t there before!
From a financial standpoint, it’s not so rosy. If you got a tax refund this year, you actually lost money.
Let’s dig into what tax refunds actually are, why it’s actually a bad thing to get a tax refund, the culture that surrounds refunds, and how you can recalibrate your mindset and tax habits for a better financial future.
How We’ve Been Conditioned to Think About Tax Refunds
Tax season is also the time of year where you start seeing and hearing marketing like this everywhere you go…
Retailers from eBay to car dealerships are invested in making you think about your refund in a certain way. It’s free money. It’s something to spend. Time to treat yourself with things that don’t normally fit into your budget.
It makes sense that companies want to market this way, even if it’s a bit slimy when you break it down. They’re mostly targeting people who don’t have much spare cash throughout the year and are susceptible to impulse purchases once they finally see a higher number in their bank account.
The problem with this, of course, is that blowing all that cash now means you have less to work with throughout the year and less to save.
Still, even if someone logically knows and acknowledges this, there’s no denying the psychological power of getting a lot of money at once. Dopamine is a hell of a drug.
Ultimately, this “tax refund = free money” mindset is working against us all in a big way. Luckily, there’s a smarter way to handle this stuff–and if you do it right, you won’t even be fazed by those April temptations.
What Tax Refunds Actually Are
In short, if you received a tax refund this year, it means ONE thing, and only one: you overpaid on your taxes during the year.
That’s it. “Refund” is truly accurate terminology, because it’s not extra money–you didn’t win the lottery. It’s simply your own money being returned to you: a refund.
Receiving a tax refund means that you’ve spent the past year giving the government interest-free loans. If you get a refund of $3000, you overpaid by $3000; that’s all there is to it.
Why Is It a Bad Thing to Get a Tax Refund?
If you overpaid on your taxes, it means that the government has been using, investing, and earning interest on that money for the past year. But it’s been your money the whole time–just effectively loaned to them–so YOU should have been the one reaping those rewards.
What kinds of rewards might you have lost out on here? Well, let’s look at average tax refunds combined with historical stock market performance.
The average tax refund is $3120, which is a pretty significant number. I’ll round down to $3000 for the sake of pretty math.
Now, if you’d taken that $3000 during an average tax year and invested it instead, using the average annual return of the stock market at 10%, you could have easily turned it into $3300.
Looking at 2017 specifically (which had a massive “bull market” run of 25%+), it could have grown into $3750 or more.
Better yet: you wouldn’t even have missed that money if you had invested it. Since you paid it in taxes, you were living without it anyway!
It might seem a little counter-intuitive since most of us are accustomed to thinking of tax refunds as a good, exciting thing, but from a financial standpoint, the best refund is a $0 refund.
How to Stop Overpaying on Your Taxes
Luckily, this situation comes with a relatively simple fix. If you received a refund this year (meaning you overpaid), all you need to do is adjust how much you’re paying in taxes so the same thing doesn’t happen next year.
If you’re employed traditionally (i.e. you receive a W-2 from your employer), this means adjusting your withholding amount on your 2019 W4. It’s important to update your W4 whenever you experience a new life event, because you may qualify for less withholding if your marital status changes, or your family size changes. In addition, the W4 form was overhauled in 2018, so you should update it to make sure you don’t get too much money withheld from your paycheck.A W-4 is simply the form given to your employer so they know how much to take out of your paycheck and send to the IRS or invest for you in a 401(k).
Getting too much back in taxes means you should be claiming more “allowances” on your W-4, which will reduce the amount of money taken out for taxes each paycheck. Number of allowances should be found in box 5 on your W-4. You can go over this with your payroll department, but if you got a big refund last year, you should increase your number of allowances by at least 1.
To get a clearer picture of what your paycheck and taxes will look like with various amounts of allowances, plug your details into this payroll calculator. This will help you be as accurate as possible when adjusting your W-4 for real.
It needs to be emphasized that this is especially important going into the 2019 tax year. The standard deduction is nearly doubling for both individuals and couples, meaning that if you’re making the same wage or even slightly more, you should be paying less on your 2019 taxes than you did for 2018. If you don’t adjust your withholdings, you could end up overpaying by a significant amount.
If you’re self-employed or own a business and received a refund, you don’t have a W-4 to adjust. In that case, it simply means you should send lower quarterly tax payments to the IRS–as long as they’re not so low that you underpay either.
After you adjust your withholding, I suggest comparing your paychecks to see how much extra you’ll be getting. Then, take that amount and invest it. (Find a guide on investing for beginners here.)
You can set up recurring contributions to an IRA so this happens automatically. If you struggle to save when the money is in your hands, you could even just increase your contributions to your workplace plan. This way, your paycheck is the same as it was before, but the money is going to retirement savings instead of overpaying taxes.
At the end of the year, you might be surprised at how much you find in your account. As a reward, you can even take a fraction of those savings and treat yourself to something you’d normally get with your refund, like a trip (and pay for some of it with credit card points!).
If you don’t feel ready to invest, you could always set up a high-interest savings account to funnel your extra money into instead. I use Ally, which currently pays 1.45% APY. On the average person’s refund of $3000, that’s about $44. Not crazy, but better than the $0 of interest you’ll get from Uncle Sam.
Remember: The Best Tax Refund Is No Tax Refund
If you’re accustomed to celebrating your refunds, it may take a period of adjustment to shift your thinking. After all, it’ll probably give you less of a dopamine hit to see an extra $50 (or whatever) on your paycheck than it will to get hundreds to thousands of dollars all at once.
But you know what’s better than that once-a-year rush? Watching your net worth increase, slowly and steadily. Reaping the interest, dividends, and value growth that comes with saving and investing.
Tl;dr: change your mindset, get rid of your tax refund, and make your money work for you all year instead.
Kate owns and operates content and editorial businesses remotely, which allows stints of globetrotting as a digital nomad. So far, her laptop has accompanied her to Europe, Asia, and around the U.S., mostly thanks to credit card points. Years of research and ghostwriting on personal finance led her to the FI community and Selleratheart. In addition to traveling and outdoor adventure, Kate is passionate about financial literacy, compound interest, and the Oxford comma. Visit her website.