While getting a large refund from the IRS does feel good and is better than owing money, having a tax refund as close to $0 as possible is the smarter move. Hear us out.
Overpaying on your tax withholding each paycheck is equivalent to lending the government money without being paid interest on that loan. If your tax refund is $2,400, that is $200 out of your pocket every month that could be going towards bills or your savings account, gaining interest. Plus, if there is an emergency, you will not have access to your refund until the IRS reimburses you.
Using tax overpayment as a savings system may help you set a large lump sum at a later date, but you are losing out on the interest you could be earning otherwise. If the idea behind tax overpayment is to treat yourself, you would reap even more of a reward by opening up a high yield savings account and collecting the interest along with your savings.
If the goal is to have a refund as close to $0 as possible, how do you figure out what you should have taken out of each paycheck? After all, having too much taken out isn’t the only potential problem. If you underpay, you could end up owing the IRS.
How much should you be withholding?
The more allowances you claim, the less money from your paycheck goes to taxes, and vice versa. If you get a large tax return, you should consider increasing your allowances.
You can use the IRS’s withholding estimator to figure out the right number of allowances for you.
How do you adjust your allowances?
You can find the W-4 form on the IRS’s website. Once you have completed the form, give it to your employer or your HR department for processing.
Is this a “fix it and forget it” kind of thing?
Not necessarily. If you have a significant life change like getting a raise, changing your marital status, or buying a house, you will want to visit the IRS’s website again to check any effect to your tax liability. A tax professional can help you with any specific questions you may have on your tax situation.
The bottom line
You may have conditioned yourself to look forward to the excitement of a large tax refund check in the mail each spring. However, with more money from each paycheck going into interest-bearing accounts, you can reach your goals faster by not getting that tax refund. Combining your extra money each month with a sound budget will have you moving toward your financial goals.
For more information about taxes and savings, visit our partner Balance.
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