According to surveys and IRS data, approximately 59% of Americans are expecting to receive a tax refund this year, with an average refund amount of $2,894. This means many tax payers are letting their employers deduct way too much from their checks.
While anyone can adjust their withholdings at any time by requesting a new W-4 form, many Americans may rather receive that large check at the end of the year.
The ideal is to neither owe nor receive anything
According to the results of a survey of 1,500 adults by American Express, approximately 59% of Americans expect to receive a tax refund this year. The IRS reports that the average tax refund through March 8 has been $2,894.
Of the respondents in the American Express survey, 37% said they would use the money to pay down debt or bills while 26% said they planned to save the money. A little more than a quarter of respondents said they were going to spend the refund on travel, family or other purchases.
In a perfect world, no taxpayer would owe money or receive a refund when they file their taxes. Common financial advice says to adjust your withholdings on your W-4 to ensure that you’re paying the right amount of taxes throughout the year.
Receiving a refund means you’ve let the federal government hold onto some of your money all year long. Worst yet, the IRS does not owe you interest when you overpay and as many financial advisors will say, “You’re giving them a free loan.”
Mari Adam of Adam Financial Associates in Boca Raton, Fla., says the worst case scenario is when people owe large sums of money at the end of the year. For most ordinary workers, it’s not an issue because some level of taxes are usually deducted from their paychecks.
“Most people don’t have money available when they need to write that check. It’s perhaps better to overpay a little than to underpay,” says Adam. “You generally want to try to avoid owing money.”
Refunds could be put to better use throughout the year
In most cases, the thought of letting the federal government sit on your money all year would sound like a losing proposition. It might be better to receive that money a little bit at a time in every paycheck throughout the year.
Kimberly Foss, founder of Empyrion Wealth Management and author of Wealthy by Design: A 5-Step Plan for Financial Security, says this is especially important if the person is carrying high interest debt.
That’s because putting that money towards the credit card balance throughout the year could significantly reduce the interest they would pay than if they made a lump sum payment with their refund.
Even if a consumer has little debt, the extra money in their checks throughout the year could prevent them from having to turn to credit cards if they live paycheck to paycheck.
“If it means you’re only making the minimum payments [and pay more interest] or if you’re going to turn to credit cards to cover expenses, then you should adjust your W-4,” says Foss.
For a worker that gets paid biweekly and receives a $2,800 refund, adjusting their withholdings would give them an extra $107 in each paycheck. That’s a substantial bump in take-home pay that seems like it could be put to better use throughout the year.
But in reality, many workers may increase their living expenses and may spend much of that difference.
A “forced” savings plan could be good for some
Despite the fact that millions of Americans are letting the government sit on a large chunk of their money all year, that large annual tax refund may serve as a “forced” savings plan for many taxpayers.
A 2012 survey by the American Payroll Association found that more than 68% of Americans are living paycheck to paycheck. Those respondents said it would be “somewhat difficult” if their paychecks were delayed for a week.
Even if they have money leftover every paycheck and have the ability to save, many lack the discipline.
Less than a few years ago, the personal savings rate in the United States was near zero and according to a survey by the Employee Benefit Research Institute, more than half of Americans have less than $25,000 in savings and investments, excluding their homes.
Receiving a lump sum $2,800 check in April is the only way that some Americans can save.
“For people that can’t discipline themselves to save money throughout the year, this might be a viable way to at least help create an emergency fund or help fund an IRA,” says Foss.
A tax refund can serve as a forced savings plan because it is automatically deducted from the employee’s paycheck delivered in a lump sum. This removes the ability to automatically spend it throughout the year. For many, it’s much easier to deposit a $2,800 check in their savings account at the end of the year than it is to set aside $75 per week for 52 weeks.
“Many people just don’t have the discipline. It’s a nice chunk of change for them in April,” says Foss.
In theory, the taxpayer would be losing money by giving Uncle Sam an “interest-free” loan, but that’s not the case had they otherwise spent that money in each paycheck.
And with the average money market account paying only .5%, a taxpayer with a $2,800 refund would only be losing out on $14 in interest. That’s about $1 per month.
One might consider it an administrative fee for a plan that essentially forces them to save money.
Craig Guillot is a business and personal finance writer from New Orleans. He covers insurance, investing, real estate, retirement and debt. His work has appeared in such publications and web sites as Entrepreneur, CNNMoney.com, CNBC.com, Bankrate.com and Investor’s Business Daily. He is the author of “Stuff About Money: No BS Financial Advice for Regular People.”