I know you’ve probably tried to put it out of your mind, but tax season is just about on us. Yes, you don’t HAVE to file until April 15th, but why put it off until the last minute? (Besides tradition, of course.) Most of your tax documents should have been sent to you by January 31st, or more likely nowadays, are available online when you check your investments or savings.
Even though we’re just getting into the 2010 tax season, it’s not too early to get ready for 2011′s taxes. In fact, now is probably the best time to begin your preparation for next year; changes you make now to the amount of withholding you ask your employer to take out of your paycheck will have a great effect on how much you owe next year, and these can easily be calculated by any of the free tax prep software packages available online. But the question is, should you aim to make your refund as small as possible (thus getting more money with each pay check) or try for the largest refund possible (cutting down your take home pay throughout the year in order to do so)?
The most common advice I’ve heard is try to minimize your potential refund. It makes sense; after all, every dollar you get in your refund is a dollar that you (over)paid in taxes initially. On the other hand, as Green Panda Treehouse and the Financial Samurai note, there are advantages to getting a sizable refund, as well. Let’s look at both sides of this issue:
Small Refund Pros
-More Money Throughout the Year: The biggest advantage of aiming for a small refund (by putting as many allowances as possible on your W-4) is that you’ll get more money with each paycheck (as less will be withheld for taxes). This means more for spending, more for investing, more for saving. If you aren’t giving the money to the government, that means more for you in each paycheck. Speaking of the government…
-No Interest-Free Loan to the Government: Whether you want to avoid giving the government more money than needed or just want to do your part to keep the national budget under control, minimizing how much you have taken by the government can be a goal in itself. A small refund is proof that you succeeded in that goal.
-No Temptation to Treat the Refund like ‘Found Money’: Every year around this time, you start to see advertisements for companies offering sales, specials, and other inducements for people to spend their tax refunds. You even hear about ‘refund anticipation’ loans where companies will offer to let you buy things with the money you’ll get from the government, before you even file your taxes. This trend of treating a tax refund like money from heaven (rather than a refund of your own money to you) is one reason to consider increasing your allowances and minimizing your refund.
The Advantages of a Large Refund
-Lump Sums are Easier to Utilize: If you have financial goals you’re working to meet, a lump sum is easier to put to work for you. If you want to build an emergency fund (always a good idea), it’s simple to take a $1200 refund and say, ‘Well, that’s a pretty decent bare bones fund’. If you got that same $1200 throughout the year (in the form of slightly larger paychecks), you would need the discipline to put it away a little bit at a time, $25 or so every two weeks. Many people just don’t have that discipline.
-Less Temptation to Spend Throughout the Year: Here’s a simple fact: if you don’t have money, you can’t spend it. (Well, you can if you use credit cards and carry a balance, but none of my readers would do anything that foolish, right?) If you are getting less money in each paycheck because you are paying more in taxes, there will be that much less available for you to spend, (hopefully) helping you to rein in your finances. (This is also a major reason financial advisers will tell you to increase the amount you contribute to your 401(k); less money taken home means less temptation to go crazy with spending.)
-No Risk of Owing Taxes: Sometimes forgotten in the argument over whether to shoot for a small tax refund is the fact that you can overshoot and wind up owing the government money. Much as getting a few thousand dollars can allow you to easily complete one or more of your financial goals, finding out that you owe the government hundreds or thousands of dollars can empty your emergency fund and possibly derail some of your plan. If you ensure that you overpay throughout the year, you’ll never find yourself in that situation.
This is a tough one; either option could be good, depending on how you utilize money. The biggest question is, what would you do with a sizable refund? If your answer is something financially responsible, like bulking up your emergency fund, investing it, or paying down credit card debt (hopefully not credit card debt you’ve accumulated since paying down your balance last year with a tax refund), then giving the government an ‘interest-free loan’ is not going to hurt you. You’ll get the money back next year, anyway, and it probably won’t be bad to get used to living on a smaller paycheck in the meantime.
On the other hand, if you look at a tax refund check as an excuse for prolific spending for a short period of time, then taking steps to minimize the amount you’ll receive is probably the best course of action. Assuming you have decent spending and savings habits (which is admittedly a big assumption), a slightly larger paycheck each week could prove less of a temptation than a single lump sum. You should also shoot for a small refund (or even owing money) if you vehemently oppose giving the government any more money than you absolutely must AND you’re willing and prepared to owe money when you file your taxes.
For myself, I’m reconsidering my previous belief that minimizing your refund is best, and I’m leaning a bit toward claiming fewer allowances on my W-4 when I am next hired. Besides helping to discipline my monthly spending, I think I have enough discipline to put most of the refund money towards good financial goals (like rebuilding my emergency fund). But you have to do what you think is right for your own personality.