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Why ‘Refund’ is a Four-Letter Word

Nobody likes filing taxes, but everyone likes a refund. It’s free money, right? Whoa…before you celebrate with a new big-screen TV, think about how your refund gets there. It might not really be the free money you think.

How the refund process works
When you start a new job, you completed a W-4 to select your federal tax withholding level. Every paycheck, your employer withholds a percentage of your gross pay and sends to the IRS. If you’re withholding the right amount, the IRS should get the taxes it’s due. The withholding formula is designed to protect people from having to cough up money in April. For many Americans, this would be a significant hardship. So, the withholding formula errs on the side of over-withholding.

On your tax return, you want to include all deductions and credits — this will make your income lower than your employer was estimating. That means you get a refund, and the government pays back some of the money it withheld.

So, all year long you’ve given the government an interest-free loan. If that amount were in your savings account earning interest, you’d actually have more money to spend!

What to do instead
You can fill out a new W-4 any time during the year (especially important to consider if you’ve had a change like marriage or a promotion with a pay increase). Use the IRS W-4 calculator to view different scenarios to determine if you need to adjust your withholding. It’s better to overestimate than underestimate your tax payments.

Adjusting your withholding could mean another $200 in your pocket every month! (If that $200 would just slip through your fingers, it might be better to let the IRS hold it for you.) If you have a plan for that money — and stick to it — the paperwork may be worthwhile. Here are a few ways to put that money to work.

  1. Use it to pay down high-interest debt. Paying off a credit card balance with 20% interest is like getting a no-risk 20% return on investment.
  2. Start an emergency fund. The cause of most debt is an unexpected expense on a tight budget. Using cash for car repairs, medical expenses or an unexpected bill avoids credit card debt.
  3. Increase your contribution to your 401(k) program or IRA. This reduces your tax burden and raises your quality of life down the road.
  4. Use the extra income to start a money-making side project. With a few power tools, a bucket of paint and imagination, you could turn curbside furniture into treasures!

Whatever you do with your money, you don’t have to wait until April to get it!