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Home » Taxes, Workplace Finance

3 Reasons why Tax Refunds are Bad & how Allowances can Help

Last updated by on 31 Comments

Tax Allowances Are Key to More Income

Tax allowances are the key to more income throughout the year. Unfortunately very few people know how they work. It’s that time of year when many people start to get giddy about getting that fat tax refund they’ve been waiting for. According to the IRS, the average tax refund last year was a whopping $2,803. Surely, visions of HDTV’s, laptops, and smartphones are dancing through the heads of many. What many of us, particularly younger professionals, don’t realize or don’t want to accept, is that getting that huge refund is really a poor financial strategy.

tax allowancesThe reason why anyone would be able to receive a huge refund is mostly going to be due to the fact that they were paying the government too much withholding tax on their income throughout the year in the first place. A lot of people realize this, but don’t seem to know how to take action. Personally speaking, I have fallen into that psychological trap as well, where you think by getting a large refund you are somehow better off financially for it. Getting that large check in the mail feels like a huge blessing. Quite the opposite is true.

The Drawbacks to getting a Large Refund

1. You are loaning your money for a negative return. Getting a large refund means you are paying more in taxes throughout the year. This money could easily be going into your bank account and earning interest throughout the year. Let’s say that you invest the extra income in mutual funds and you earn the stock market historical average, in effect you’re loaning the government your cash and in return for your kind offer you are giving them a good chunk of cash. Even if you just put the money into a high interest checking account that returned 4% a year, consider it a 4% loss on the amount of your refund.

2. You are binging and purging your cash. Getting more of your true income delivered to you on a consistent basis allows you to work it into your budget. If you direct deposit this income into your savings, you don’t miss it at all. The urge for many, when they receive a big refund, is to go out and spend it because they feel that they deserve it. They do, after all, it’s their hard earned cash! If you set yourself up to not get that big refund, there’s no urge to purge.

3. You are not able to distribute investment risk evenly over time. Part of any good investment strategy is to distribute risk of loss buy adding investment contributions over time. Even if you wisely invest your refund versus spending it all, you would most likely be making one large contribution versus spreading out risk over the year. This is a bad investment practice.

The Basics of Withholding Tax Allowance Exemptions

A withholding tax allowance is simply a number than you can claim on your W4 form that will change the amount of your income that your employer will withhold from you throughout the year. The number of allowances can vary, but is most likely 0, 1, or 2. The higher the allowance number, the less tax will be withheld from you with each paycheck. A W4 is filled out by an employee when they start employment.

Allowances on a W4 can be updated at any time by filling out a new one. Most employers will allow you to do this whenever you desire (and as often as you desire), and your withholding tax amounts should take effect in your next full pay period (this may differ by employer, so ask yours).

Don’t Take Tax Allowances Too Far

On the other end of things, you don’t want to end up owing the IRS significant money and possible penalties. Just be careful

Your End Goal with Withholding Taxes

Ideally, at the end of the year, you will benefit the most if you receive a very small refund (close to nothing) or end up paying a very slight amount that you will be able to easily pay. One caveat when changing allowances: the last thing you want to do is end up with too high of an allowance that results in you owing a high amount that you are unable to pay.

How can I Figure out what my Tax Allowance should be?

Fortunately, there are at least three free resources available to you, which are cited below. If you still are having trouble figuring out what your allowance should be, you may want to speak with your employer’s payroll department or a qualified tax professional.

Will you be changing your allowances in the coming year?

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I am G.E. Miller, & this is my story. My goal is financial independence ASAP. If you share that goal, join me & 7,500+ others by getting FREE email updates. You'll also find every post by category & every post in order.


31 Comments »
  • Dan says:

    Great insight G.E. I’ve always received a tax return and placed it directly into savings or an investment vehicle. It never clicked that I could be using the added income over the year to better take advantage of dollar cost averaging. I do, however, eat Vizios for breakfast.

  • G.E. Miller says:

    Thanks Dan. You know what they say – “A Vizio a day keeps the doctors away”.

  • Michael says:

    Ahahahahahaha! Great, great.

    Being my first year employed I had no idea what I was picking when I did the allowances. I ended up going with 3. I guess that was a good move!

  • G.E. Miller says:

    Three is pretty high, how much did you end up owing? The one thing that should be avoided is owing so much that you actually incur an interest penalty.

  • Michael says:

    Federal tax I didn’t owe anything. Got $400 back. State tax I owed $181.

  • G.E. Miller says:

    Excellent, that’s right where you want to be. Unless you significantly change your 401K contributions or change jobs, you probably don’t want to change a thing.

  • Freddie says:

    I am married with 1 child and I am the only one working. I brought in about 48K last year and received close to 6k in my refund. I used the IRS calculator and it told me to change my withholdings to 8! Is that correct? It stated that I would get about $75 back next year if my financial situation did not change. 8 just seems like too much…

  • G.E. Miller says:

    Wow, I’ve seen 3 or 4, but never seen an 8! Pretty impressive, Freddie. I’m surprised with only one child it suggested you to claim that high. Do you have other dependents (other than your wife)? $6K is a huge refund, and in supporting your wife and a child, I’m sure that money distributed throughout the year more evenly to you may come in handy. My suggestions would be to try out a few different allowance calculators, and if they all come back with an 8, then go with it. Receiving a $75 return is a good scenario. If you’re still feeling a little weird about it after that, then you may want to consult with a CPA.

  • stephanie says:

    I agree with Dan – thank you so much for #3! I have received my refunds back, but stuck them in a savings account to deal with later, intending to put them in my Roth IRA when I get around to it. Now I’m thinking maybe I’ll just increase my Roth contribution to spread that out over time instead of making a lump sum contribution – I definitely would not have thought about that before reading this article.

    Also, I have known for a few years that letting the government keep your money interest-free all year is not beneficial, but this past year is, I think, the first year I’ve ever had where I actually would have invested or saved it had I been paying less in taxes. So how do I change my withholding for the rest of this year to try to get more of my money for the rest of the year? Or I guess maybe I should just contact my Human Resources Department and ask them. . . lol.

  • G.E. Miller says:

    Hi Stephanie, yes, I’d recommend trying out the calculators to see what they recommend, and then speaking with your H.R. department – they’ll be able to help you with changing your allowances, which you should be able to do at any time throughout the year.

  • Andrew says:

    ppl tend to blow their tax refunds
    but, ppl tend to blow pay checks too

  • J.D. says:

    Question: Can I claim a really high amount of allowances in order to more closely estimate my final tax liability? I will only be working for a few months and don’t want to pay taxes every 2 weeks where the withholding is based on an estimate of what I would make if I worked for the rest of the year. I used a tax calculator and figued out that if I claim 14 allowances my bi-weekly withholding will be just slightly over my end-of-the-year tax liability (giving me a very small return), which is exactly what I want. My only concern is that the IRS is going to take notice of my claiming 14 allowances…

    • Natalie says:

      This is between you and payroll, not you and the IRS. The IRS will only get involved if, when you file your return, you owe more than $1000 and 10% of total tax owed. Look at the rules for underpayment penalties. The IRS doesn’t know or care how many exemptions you told payroll to do. Some companies require that you make the request in person if you are claiming a large number of exemptions. I’m sure if you show payroll your numbers they will cooperate.

  • G.E. Miller says:

    @ J.D. – it looks like you’ve run the math, but as to whether or not the IRS will take notice of 14 allowances, I’m not quite sure. If it’s something you’re concerned with you may want to consult a tax professional, I’d hate to lead you astray.

  • William says:

    I agree with Andrew…
    I think that most people will not save with weekly or biweekly checks, instead prefer geting a thousand or so check in march or April over $40 dollars extra a week…
    If you are already leaving on that budget or schedule, I suggest keeping it that way, because it is more likely that you are going to spend it as it comes in… consider it a savings account.. (by the way the amount the government makes on that money over the span of a year is minimal – consider that the first couple of months there isn’t much earned on that account)… Enjoy that that free money in april..

  • G.E. Miller says:

    @ William – The problem is that people tend to view a refund as ‘bonus’ money that should be spent as a reward. If they were to get an extra $40 per week I would think that they would tend to value it more as hard earned income and work it into their monthly cash inflow/outflow. Anyone have data on the percentage of people that spend all of their refund?

  • sheehan says:

    receiving a tax refund is better than owing money to the government. most people don’t have $2K to just pony up at any given amount of time. this eventually leads to fees, debt and what not.

  • CJEH says:

    We’ve always gotten a large tax return, have never owed taxes, and we’d like to start having that money coming in during the year, but the numbers I get off the IRS calculator seem pretty unbelievable.
    After plugging in my cottage-industry income (less than $1000/year), my husband’s salary (about 75k), kids, mortgage interest, FSA, 401k, ect… the IRS wants us to take *20* allowances!

    Now, I know they’d much rather us pay, then them owe us money, but that seems pretty crazy. How can I find out where a safe line is? How much money will end up in our checks per allowance anyhow?

  • Cj says:

    Just completed our joint tax filing and ended up owing the Feds about $1700. I was claiming 2 and my husband was claiming zero and we still had to pay. We have a daughter in college and are filing for divorce this year. My income is about $80-$85k. Any suggestions on what I should set my tax allowance for this year??

  • torg says:

    Means if not to do overpayment that return it is unnecessary better really this money to invest

  • diane says:

    With Obama’s announced work credit for 2009, I read somewhere that a person who receives a pension and also works might wind up paying more taxes. So, on the consul of my accountant, I changed my allowance from 1 for both state and federal to o. My pension check reflected the change. Bottom line payroll check to me reflected the difference. But, payroll check very confusing. Less tax taken for the year??? Wound up owing more money!! Shouldn’t amount of paycheck reflect change??? I have two check stubs..one when the allowance were 1…and one when they were changed to 0 and net amount to me was the same!! I think payroll people somehow goofed but it is a payroll service (ADP) and, I am given the impression by my employer that there is no one I can talk with!! HELP!!

  • jp says:

    I’m getting divorced and we have one child. I make about 80k more than my wife and our mediator told us that I should declare single on my taxes, claim 2 for me and my son, and claim 20 withholding allowances to boost my salary and pay the child support and spousal support. Does anyone know if this seems right? THe mediator claims that I still will not owe any taxes at the end of the year. She says my wife should claim head of household, and let me claim our son, and that it will work because I can deduct sopusal support.

    Any advice greatly appreciated.

  • create pay stub says:

    We must play on our duty, the citizen must response to pay tax, in order to develop their country. Also if they have a right to refund their tax, the action must be done too (get money back or give it to gov are choices). Avoiding tax is not the option for good people to do.

  • Samsung plasma hdtv says:

    We must pay tax, but never increase tax will make our country become a great place for all citizen.

  • Natalie says:

    JP, or anyone in this situation, you deduct alimony paid from your income come tax time, but not child support. So be very clear about what you are paying for each.

    For example, you have 80k income and you are paying 30k in support, but only 10k is alimony. You should probably claim single with 3 or 4 exemptions. The standard exemption is currently $3650 so for each $3650 that you are paying in *alimony* you should increase your withholding by one exemption.

    To rightfully claim 20 exemptions, you would have to be paying 73k per year just for alimony. If this is the case, do it.

  • Natalie says:

    I think these figures are a little skewed by EIC. I see people all the time with low income who have 2 or three kids and get 6k back on their taxes. (Yes I’m a tax preparer). They certainly didn’t pay in that much, but with 3 alternative child tax credits and EIC it adds up quickly. These people use the money to survive. They are usually late on rent and bills and this is their only opportunity to catch up. The high figure is generally not coming from young professionals who pay in too much.

  • j says:

    this is an oversimplification of the trade-offs involved. I save 40% of my income so I would use this approach. However, most Americans do not. As a rule they spend 113% of what they earn in their paychecks. If it were not for this financial babysitting many people would be further in debt, than they already are.

  • Jim says:

    Question:
    I’m recently divorced and paying significant alimony and child support and have quite a bit of charitable deductions. That being the case, can I legally claim W-4 exemptions for being married? I changed them to Single and my taxes jumped about 30-50%,but I’m SURE I’m overpaying and will just get a big tax refund — I’d rather have the money now.

    Jim

  • RNT says:

    My strategy is a bit unorthodox, but takes all the guessing out of tax withholding. I claim 99 exemptions (which basically means that my company does not withhold anything) and then in the box on the W-4 form that asks if you want any additional withheld, I put in the exact amount that I want withheld. I determine this exact amount by basically doing my taxes in advance. I determine what the yearly tax rate is on my income, and adjust for deductions. Once I know what my liability will be for the year, I just divide that by 24 (I’m paid bi-monthly) and I’m done. Works out nearly perfect every year. Of course, if you get a raise or something, you have to recalculate, but otherwise, you are set. This means you are maximizing take-home pay, but ensuring that you don’t owe anything at the end of the year either.

  • Justin says:

    I have a bonus coming up soon. I want to change my tax deductions this one time only to get the full bonus amount & have little to no taxes taken out. Can someone tell me how I can do this? Thanks, J.

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