If you’re an average American taxpayer, you probably dread tax time. After all, filling out all that paperwork can be a drag.
But for many taxpayers, tax time is also great — it’s the one time of year when the government sends you a big check. Near the end of the 2018 tax season, the average tax refund was $3,062, according to the Internal Revenue Service. And by March 23, 2018, the IRS reports it had doled out nearly $198 billion in tax refunds.
So if you’re like many Americans, you’re looking forward to that giant check. Maybe you’re planning to pay off debt, do some home renovations or go on vacation. These are all good things. But getting that tax refund in the first place may not be.
What a Tax Refund Means
Here’s news for you: Unless you qualified for tax credits, your tax refund isn’t a gift from the IRS. In fact, when it writes that fat refund check, the agency is just giving you back money it owes you.
In other words, when you get a massive tax refund, it means you’ve loaned the government money from your paychecks throughout the year. And the government is not paying it back with interest.
A tax refund generally indicates you’ve paid Uncle Sam too much with each paycheck. We’ll talk about why that might be in a moment. But let’s first discuss some other things you could have done with that money throughout the year.
[See: Answers to 7 Burning Tax Questions.]
A Better Use for Your Funds
What could you do with that extra $3,000 if it came to you in increments of $115 in each biweekly paycheck? It’s easy to just blow that extra money without even realizing it. But if you’re smart, you could do one of the following:
1. Pay down debt.
Let’s say you’ve got a credit card carrying a $2,500 balance at 18 percent APR and a 2 percent minimum payment. Starting in January, you decide to pay $50 a month toward the credit card. Then, you’ll pay off the balance with your tax refund check. By December, you’ve paid $600 toward the card, but you still have a balance of around $2,354 left because of interest.
But what if you put an extra $233 a month into the card throughout the year? Now you’re paying $283 per month. In this case, your credit card debt is gone by October, and you’ll only pay $202 in interest. And all you have to do to make this possible is ask your employer to keep your money in your paycheck by changing your withholding (more on this below).
[See: 10 Low-Tax Places to Retire.]
2. Save for retirement.
Many people put a chunk of change in retirement savings when they get a tax refund. This sounds like a good idea, but when you do this, you miss out on up to a year’s worth of accumulating interest for your retirement savings.
Let’s say, instead, you start a 401(k) this year, and you only put in that $233 per month you would have gotten in your tax refund. In an account earning 6.5 percent interest, compounded monthly, you could end up with a balance of around $2,881. That’s an extra $85 you wouldn’t have gained in interest otherwise.
Then, that $85 will compound and add more interest the next year. And the more years you carry on in this fashion, the more interest you’ll gain.
How to Fix the Problem
Obviously, paying off debt and saving for retirement aren’t the only reasons to stop paying the government more than you owe. But they’re smart ways to use that extra $115 per paycheck.
So if you’re interested in getting that money back into your paychecks, how do you go about fixing the problem?
It all comes down to one form: the W-4.
This is the form you’ll fill out every time you start a new job. It basically tells your employer how much of your paycheck to withhold in federal taxes. On this form, you can claim exemptions for dependents, having only one job, having a non-working spouse or paying for child care, among other things. The more exemptions you have, the less will be withheld from your paychecks in taxes. Meanwhile, the fewer exemptions you claim, the more your employer will withhold from your paycheck.
If your tax refund was rather large, you likely didn’t take enough exemptions. Often, employees forget to change their forms after a life event, such as getting married or having a baby.
To update your exemptions, all you need to do is ask your employer for a new W-4. You can also check out this IRS withholding calculator, which the IRS recently updated following the new tax law, to figure out how much your employer should withhold from your paychecks.
[See: 10 Smart Ways to Spend Your Tax Refund.]
Before You Change Your W-4
Now, we’ve spent all this time talking about how it’s not good to get a huge tax refund. For most of us, it’s not. However, if you don’t have the discipline to use that extra $115 (or whatever your amount may be) wisely, don’t change that W-4 just yet.
For many of us, it’s easy to devote a large lump sum to a responsible purpose like fixing the furnace or paying off a credit card. But in the grand scheme of your monthly budget, it’s easy to fritter away an extra $115 per paycheck and let it slip right through your fingers.
If you don’t think you’ll have the discipline to stick to using this extra money for good purposes, you may just want to keep making Uncle Sam those interest-free loans. You know that come next tax season, he’ll pay it all back, and you can use the money wisely then.
Still, building the discipline of saving money or paying down debt is important. And properly using your W-4 form can be a painless way to get started.
More from U.S. News
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7 Most-Missed Tax Deductions and Credits
Excited About That Big Tax Refund? Think Again. originally appeared on usnews.com
Update 04/06/18: This article was originally published on Feb. 22, 2015 and has been updated to include new information.
