OVERVIEW
Looking forward to a large refund? That might mean your withholding is too high.
Putting your refund to good use is a state of mind
Your annual tax refund can underwrite a summer vacation, a week's worth of groceries or any number of investments, depending on your personal circumstances. But the effectiveness of your decision might have more to do with how you think than how much you earn.
Financial planning experts say that people in vastly different financial situations often have one thing in common: They base their decisions on how to use their tax refund on the misconception that it’s a gift from Uncle Sam.
They don’t regard refunds as earned income. But they really are part of your earnings, the experts said, and they advise you to plan accordingly.
"If you were going to spend all your raise, then that’s probably what you should do with your tax refund. If you were going to put some more in your 401(k) or some kind of savings, then that’s what you should do."
—Bob Burger, Murphy Capital Advisors LLC
Reduce your debt, increase your savings
Bob Burger, a financial planner with Glendale, Arizona-based Murphy Capital Advisors LLC, likens the typical thinking about tax refunds to a gambler’s mindset. A gambler, Burger said, views the ante as separate from the winnings.
“The way they see it, that first $1,000 is mine. The second $1,000, that’s Vegas’s, and I can do all kinds of crazy things with it because that was never my money in the first place,” Burger said. “I fear the tax refund is no different.”
In fact, however, it’s neither a gift nor a poker pot. It’s money that you earned during the previous year.
There is no single approach to allocating your tax refund, though the experts agree that it’s wise to knock down debt at every opportunity. Burger suggested that taxpayers think of the refund as a raise and treat it as such. Adopting this mindset could be the difference between funding a more robust retirement account and blowing your refund on something frivolous—such as a $1,000 hand of blackjack.
“If you were going to spend all your raise, then that’s probably what you should do with your tax refund,” Burger said. “If you were going to put some more in your 401(k) or some kind of savings, then that’s what you should do.”
That’s no fun, of course. Instant gratification is part of the joy of the refund. But remember, the refund is essentially the government’s repayment of a no-interest loan that you were forced to make. So the fun is on your dime, not the government’s.
Mix business with pleasure
Pleasure doesn’t necessarily conflict with sound financial practices, as long as the refund is part of a structured plan. Having fun even as you make smart decisions about your money requires being honest with yourself.
Many find that to be a challenge when it comes to personal finances, said Rett Dean, a principal with Riverchase Financial Planning LLC in Lewisville, Texas.
“They fudge a little bit or they put a rose-colored glass around something that may not be as rosy in reality,” Dean said. “Don’t take the enjoyment out of dollars you got back from the government, but at the same time make sure you’re being objective with yourself so the short-term enjoyment has a long-term benefit.”
Dean suggested treating a pleasure purchase, such as a new television, as a reward for using at least part of your refund to improve your financial security. Concentrate on high-interest debts first. Debts with lower interest rates, such as student loans, aren't as critical as long as you pay the minimum. If debt isn’t your biggest concern, Dean said, it’s “as critical if not more critical” to maintain a healthy “rainy-day fund.”
The rule of thumb for a reserve fund is three to six months of expenses, Dean said, though a specific recommendation is difficult to make without knowing an individual’s financial circumstances.
The undefined nature of tax refunds can make it difficult to budget them like regular income, which further encourages treating them like “found money.” The trick, then, is to make a plan ahead of refund time while basing your daily budget on your regular paycheck.
“A lot of times I hear about people who say, ‘When I get my tax refund I’ll do that,’ ” Dean said. “The concern and fear I have when I hear statements like that is they are counting on it being there for them. A better way to look at it is, ‘Am I being efficient enough with my money throughout the year, as opposed to waiting on this?’ ”
Treat it like "surprise money"
Then again, the “found money” mentality can pay off, depending on what you ultimately do with your refund. Andrew Feldman, president of Chicago-based AJ Feldman Financial LLC, said he places refunds in the same category as inheritances or work bonuses.
Such “surprise money” is ideally suited to “park where you can’t see it,” Feldman said. This could be in a Roth IRA, a diversified mutual fund or a fund with a target date, Feldman said.
“The next time you are surprised with this money, it will be a little more, and then a little more,” Feldman said, speaking of the balance of the fund. “All of a sudden your long-term goals are not necessarily taken care of, but addressed.”
A refund can mean you withheld too much
It would be hard to find someone who doesn’t enjoy receiving a large tax refund every spring. But financial planners say it’s not necessarily a good sign. It may mean you’re having too much withheld from your paychecks during the year.
Martha Ferrari, vice president of Halberstadt Financial Consultants Inc. in Princeton, New Jersey, said her more astute clients tend to have smaller refunds.
“They realize they are giving the government use of the money by having too much withheld,” Ferrari said. “They understand it is not a savings account and that’s not the way you handle money wisely.”
Instead of viewing your refund as your “forced savings,” Ferrari recommends setting up automatic transfers from checking to savings accounts.
“I find a lot of people that are living paycheck to paycheck, and they feel they can just pay their bills and can’t save,” Ferrari said. “But they need to adjust their withholdings [and] put that money aside into savings.”
The amount that is withheld from your paycheck is based in part on the number of allowances you entered on the W-4 you gave to your employer. If you’d like to adjust your withholding to get bigger paychecks and a smaller tax refund (or vice-versa), try our W-4 Withholding Calculator. You can test different scenarios to help predict the effect on your paycheck and next year’s tax refund. To get started, all you need is a copy of last year’s tax return and your latest paycheck.
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