Let’s say that you owed me $500. If I told you I was going to take $20 per week for an entire year out of your pay to cover your debt and then refund you any difference, how would you react? Wouldn’t you object to paying me $1,040 over the course of the year for a debt of only $500 even though the extra $540 is going to be returned to you eventually?
Well, if you get a large refund from your taxes every year you are actually already involved in a situation like I have just described. We all prefer to get refunds rather than owe at tax time, but too big of a refund only means you are giving the government too much money during the year.
Why would you want to give more money to the government than you need to? By reducing your withholding you can have access to some of that large refund you normally receive after the end of the year, evenly throughout the year.
Sometimes I hear the argument that it is a way to save money, since you do not have access to it and therefore won’t squander it during the year. This is a terrible way to look at your refund as well. You don’t earn any interest on the amount you overpay to the government, so you aren’t really “saving” money more than you are actually giving the IRS an interest free loan. With direct deposit you could have an amount that comes close to your annual refund deposited into a savings account little by little throughout the year. It will involve a certain amount of will-power in order to leave it alone and not spend it, but at least it will be there if you absolutely need it and it will be earning a little interest along the way too.
I have had more new clients in the past two years come to me than in previous years to reevaluate their withholding and make adjustments to reduce the large refunds they are used to receiving. Not surprising considering that as the economy slows down, people need to better their cash flow any way possible. How about you? Take a look at your last few returns. Did you receive a refund? Was it a decent sized refund every year, say over $700? If so, maybe you should consider adjusting your withholding and getting back some of that money during the year, rather than waiting for your tax refund each year.
The amount that someone considers a large refund will vary by individual and the situation. For some $700 may be too low to consider adjusting their withholding. Others would love an extra $10 per week in their pocket throughout the year and a $180 refund, rather than waiting for that same $700 refund someone else considers too little to worry about.
One thing to keep in mind is if your tax situation tends to change drastically from year to year, adjusting your withholding can be a trickier and on-going process. Even if your tax due amount each year is fairly consistent, you should revisit your withholding on a yearly basis to make sure you will pay in at least the minimum amount of tax you will be required to pay in during the year (the minimum amount of tax you need to pay in each year is based on your prior year tax due and is a concept known as “safe harbor”, which I will be discussing in depth in a future post).
Adjusting your withholding beats any rapid refund loan you may get every year from a retail tax preparation company, in that it is faster since you are getting it right away throughout the year and it doesn’t cost you a dime to change.
This may be another area where CPAs and other professional preparers differ from self preparation software and retail stores. A retail preparation location makes money on those rapid refund loans, so they may not recommend adjusting your withholding since they would prefer you to use their refund product each year. Self preparation software uses large refunds as a draw to get you to use their software, stating things like a maximum refund guarantee in their commercials. Software probably won’t recommend adjusting your withholding as it is more for tax preparation than it is tax planning.
However, a CPA wants to assist you in paying in as little as possible throughout the year and would rather see that money in your pocket now than waiting for a large refund. If you usually receive large refunds think about speaking to a CPA about your tax situation and if it might be a good idea to adjust your withholding.