We all get really excited when we fill in all our forms, submit all our receipts, go over our expenses, and find out we’re eligible for tax refunds. We start mentally spending it right away: this much for the house, this much for fun, maybe I’ll pay rent with this, etc. And, with direct deposit refunds now available we’re getting them faster than ever–sometimes less than a week after filing!
But as great as tax refunds are, many financial advisors say that if you’re getting a refund, you’re getting a bum real. That, in fact, a refund is a sign of poor financial management. Here’s why:
Whenever you buy something, you get sales tax added on to the price. And for most people, whenever you get paid you get a chunk of tax taken out. This goes to the state, to social security, and to the federal government and is calculated based on your W-2.
But a W-2 form is not the best way to figure out what you owe. It ignores money you may already have (in the form of bank accounts or houses) and it ignores stuff like raises, frequent job changes, etc. It’s also not updated very often, unless you’re changing jobs a lot.
So the amount of money taken out of your paycheck is often inaccurate. And that’s what determines whether your owe money or get tax refunds. Of course tax credits, stimulus bills, and dependents are also factors, but that’s roughly how it works.
Which means that when you get tax refunds, the government is saying: we screwed up. We took more than we meant to, so here’s your money back. You’re not gaining any money (save for credits and stimulus checks), you’re simply getting your own money back. Conversely, when you owe money, that’s the government saying you paid too little in taxes over the year and they would like some of it back.
Tax refunds are not free money. It is your money. This is why most financial advisors tell people that it’s better to owe money in taxes (or break even) than to get a refund. The money you get back in tax refunds once a year is money you could be earning interest on throughout the year.
Of course, tax refunds do have a lot of benefits. For example, people are more likely to save them then they might be if the money was just in their checks during the year. Additionally, getting a large chunk of money at once can help you take care of expenses that it’s harder to save up for. But the truly smart tax filer focuses on tax credits, which are free money, over tax refunds, which is just their own money given back to them.