If you feel like you win a mini lottery every year in the form of a tax refund, you are not alone. According to TurboTax, nearly 75 percent of Americans receive a tax refund year after year. Tax refunds are a result of your employer holding back too much money from your pay to cover the income taxes you owe. Reducing tax withholding produces bigger paychecks, which can be better than getting a large tax refund.
Withholding and Paychecks
The income tax is a pay-as-you-go tax, so you pay taxes on your income as you earn it. Employers are required to withhold money from your pay and send it to the Internal Revenue Service. The amount that your employer withholds is determined by the information you provide to your employer on tax Form W-4. On the form, you designate a number of tax exemptions based on your employment and marital situation as well as having children. The larger the number of exemptions, the less your employer withholds from your income, which results in bigger paychecks and a smaller tax refund. If you set your tax withholding too low, you may owe additional taxes at the end of the year instead of receiving a refund.
Receiving bigger paychecks is better than getting a large tax refund in that you have access to your money when you earn it. From a purely financial standpoint, getting money now is better than getting money later. You can save or invest money you have now to earn a return and end up with more money in the future: money you have now is worth more than money you don't have yet. When you wait for a tax refund, the IRS sits on money that you could be saving or investing.
A big tax refund may be preferable to larger paychecks if you spend impulsively and have difficulty saving. When your employer withholds too much from your paycheck, it is a form of forced savings: the excess withholding is still your money and you eventually get back. If you aren't able to stick to a personal savings plan, a tax refund can provide you with the means to afford things you'd normally have to save up for on your own, like a vacation or a new computer. Opting for higher withholding also makes it less likely that you’ll owe the government additional taxes when you file your return.
The exemptions you claim on Form W-4 when you first take a job are not set in stone. You can request and submit a new W-4 to your employer at any time to change your withholding and alter the size of your paychecks and tax refund. If you've had major life changes since you first took a job, such as getting married or having kids, there's a good chance your employer is withholding too much. The IRS provides a tax-withholding calculator to help you figure out what to claim on your W-4.
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