Your Tax Refund Is A Receipt, Not A Bonus

The year I got a $4,300 refund I told people about it like I had won something. I bought a sofa.

What had actually happened is that I lent the federal government $4,300 across twelve months at zero per cent interest and then filled in a form asking for it back.

The sofa is still fine. The reasoning was not.

Where a refund comes from

Every paycheck, your employer takes out an estimate of the federal income tax you will owe and sends it in on your behalf. That is withholding, and the estimate comes from a form called the W-4 that you probably filled in on your first day at a job, possibly a job you no longer have.

At the end of the year your real tax gets calculated on your return. If the total withheld was more than the total owed, the difference comes back to you.

That difference is the refund. It is not a payment from anybody. It is a correction.

The monthly number

Published average refund figures bounce around by year and by source, so skip them and use yours. Take last year's refund and divide it by 12 if you are paid monthly, or by 26 if you are paid every two weeks.

A $3,600 refund is $300 a month. On a fortnightly schedule it is $138 a paycheck.

$300 a month is a car payment. It is most of a monthly Roth contribution if you are trying to fund one. It is the difference between covering a $900 vet bill out of cash and covering it on a credit card you then carry for four months.

Do the same division on your state refund if you get one. A $1,900 federal refund and a $700 state refund is $2,600 over the year, which is $217 a month you have been doing without so that two governments could hold it for you.

What the loan costs

Say the $3,600 came back to you evenly through the year, $300 a month, and you dropped it into a savings account paying 4 per cent.

The balance builds as you go, so the average balance across the twelve months is roughly half the total, about $1,800. 4 per cent of $1,800 is about $72 of interest over the year.

$72 is not going to change your life and I am not going to pretend otherwise.

The number that matters is on the other side. If you carried a credit card balance at a 24 per cent APR, the annual percentage rate the card charges, at any point during that same year, then $300 a month aimed at the card instead of at the Treasury would have stopped roughly $432 of interest on the same $1,800 average balance.

Same $3,600 either way. One version earns you $72 and the other version saves you $432, and the version where it sits with the government earns you nothing at all.

The honest case for a big refund

I want to give this its fair hearing, because I have heard it from people whose judgment I trust.

For a lot of households the refund is the only savings mechanism that has ever worked. The money leaves before it can be spent, it comes back in one lump, and that lump has funded the security deposit, the car repair, the dental work. Spread across 26 paychecks at $138 a time, it would have gone on groceries and vanished.

If that describes you, do not blow up your withholding on principle.

Do this instead: set up an automatic transfer of $138 a paycheck into a savings account at a different bank from your checking, leave it alone for three months, and see whether the money is still there. If it is, adjust the W-4. If it is not, keep the refund and you have learned something worth more than $72.

Changing the withholding

The W-4 tells your employer how much to take out. You can file a new one whenever you want, as many times as you want, and payroll has to apply it.

1. 01Get your most recent pay stub and find the federal income tax withheld year to date, plus how many pay periods are left in the year.
2. 02Open the IRS withholding estimator at irs.gov. It asks for that stub and last year's return and tells you what to enter on the form.
3. 03Fill in a new W-4 and hand it to payroll or upload it wherever your employer keeps the HR forms.
4. 04Check the next pay stub to confirm the withheld amount actually changed. Payroll systems miss these more often than you would think.
5. 05Redo it after anything that moves the picture: marriage, a baby, a second job, a spouse starting or stopping work, a large bonus, buying a house.

Two jobs is where this goes wrong most often. Each employer withholds as though its paycheck is the only income you have, so both of them apply the low slices to the first chunk of pay they see, and between them they under-withhold. The W-4 has a section for exactly this and most people skip it.

The opposite mistake

Under-withholding is rarer and more expensive. Get it badly wrong and you open a return in April owing $4,000 nobody budgeted for, with a penalty sitting on top of it.

The people it happens to are predictable. Anyone who picked up a second job mid-year. Anyone whose spouse started working. Anyone with meaningful investment income, which nobody withholds on. Anyone who exercised stock options and found out afterwards how that gets taxed.

If you owed a real amount last April, that is the same signal a big refund gives you, pointing the other direction. Both mean the estimate driving your withholding is out of date, and both get fixed with the same form.

Do this

Find last year's refund amount. Divide it by the number of paychecks you get. Write that number down somewhere you will see it.

Then update the W-4 this pay period, and point the difference at whatever is most expensive in your financial life right now. A card balance, an emergency fund with $200 in it, a 401k you are not contributing enough to for the full match.

The money was always yours. The only question that was ever open is who gets to hold it for eleven months, and there is no reason that has to be somebody else.