Imagine looking over your net worth statement, to find an asset called “Interest Free Loan to U.S. Government.” As someone who tries to get the most out of every dollar, what thoughts come to you? Do you feel like this is the best place for your money?
If I told you that around 82% of American tax payers who file early are making this interest free loan each year to the U.S. Government, would you believe me? Even worse, that this average interest free loan is $2,869.
The purpose of this post is to explain what a tax refund is, how to minimize your tax refund, helping you to decide the best use for your tax refund this year.
Why do you get a Tax Refund?
If you’re expecting to get a tax refund, it’s because you overpaid your taxes throughout the year.
The tax system is set up, so that instead of you having to write one big check at the end of the year, income taxes are withheld from each paycheck. The amount of taxes withheld from each paycheck is based on how many exemptions you filed for on your W-4.
On the form, you mark the amount of exemptions you claim each year. The more exemptions you claim, the less tax you pay on each paycheck. Meaning, each paycheck will be higher.
If you decide to file for fewer exemptions, the more money will be taken out of each paycheck for taxes. This results in your paycheck being reduced.
The goal is to file for just the right amount of exemptions on your W-4, as to minimize the amount you either owe or pay.
Tax Withholding Estimator| Adjusting your W-4
There are many variables as to how many exemptions you can claim. So there is no general rule of thumb as to how many exemption you should file for.
The best way to figure out your exemptions is to use the IRS Tax Withholding Estimator.
It only takes 15-20 minutes to fill out and it will give you a very accurate estimate as to the amount of exemptions you need to file.
What to do if you get a Tax Refund for 2010?
If you do get a tax refund this year, put it too good use. It’s not free money. It’s money that’s rightfully yours, being returned to you.
The best use of a tax refund is to pay off any high interest debt. The next choice depends on where you’re at in your financial life. Wise uses include:
- Starting an emergency fund
- Paying off any low interest debt
- Using the cash to pay monthly expenses, while you max out your 401(k) employer match
- Starting a Roth IRA
- Important goals
Going Forward
Make it a habit to review your W-4, by using the IRS’s tax withholding estimator, twice a year. Once late in the year, say November, and once just after you file your taxes.
Knowing that the average tax rebate is $2,869, this small exercise can increase your cash flow on average $239 a month.
{ 6 comments… read them below or add one }
Great article. Don’t forget about state withholdings as well. The same rules apply.
Pat
I think that people are like lab rats, they have been trained by the government that getting a refund is really cool. Like you said, who doesn’t like “free” money? I have been trying to tweak my withholdings now that I am a home owner and my goal was to write a check to the I.R.S. for $1 when I submitted my taxes.
I’ve even heard people say “I know but it’s a good way to save money for large expenses.” It blows my mind. Why not have that money be automatically deducted from your pay check into a high interest savings account have it working for YOU and not the government? I’m so glad you wrote on this topic.
Of course, what classifies as a high interest saving account these days? I know some people who know some people who can pay much higher rates than the bank, but you don’t want to know what they do.
LOL! Well, I just meant that putting the money in an account like ING’s savings which earns 1.1% is better than letting the government hold onto it and getting nothing. “High” interest is relative.
“High” is indeed relative. What gets me is how the same bank can apply an interest rate to a credit card balance everyday but only apply an interest rate once per month and somehow that is legal and an accepted practice.