The average tax refund for the 2018 filing season was $2,925, as of March 23, according to the IRS. That’s a good chunk of change. What would you do if you had almost $3,000 coming your way?
“Many people get excited at the prospect of what they see as a windfall,” said Eric Rosenberg, a personal finance expert at Personal Profitability, a financial education website. “However, a big tax refund really isn’t what you should be striving for.”
Here’s why you should stop planning for a big tax refund — and what to do with the money instead:
1. You’re giving the government an interest-free loan
“The biggest reason a big tax refund is a bad thing is that you just gave the government an interest-free loan from the time the money was deducted from your paycheck and you got it back,” said Rosenberg. “It’s called a refund for a reason. That money is already yours.”
Rather than sending the money to the government, only to have it returned to you months later, Rosenberg suggested putting the funds to use in your everyday life.
He acknowledged that, with low rates now, it’s not the “end of the world” if you’re letting the government use your refund money free of interest. However, you could be doing other things in life with that money.
“You don’t have the freedom to do what you want with the money when you’ve earned it,” said Rosenberg. “It’s better to have the money in your paycheck to use as you want.”
2. You’re not getting out of debt faster
But is getting a big tax refund and putting it toward your debt an effective way to save money over time?
Accountant Eric Nisall doesn’t think so. “If you’re in debt and you’re waiting for a tax refund to make a dent in your situation, you’re costing yourself money,” he said. “Allowing interest to build up on high-interest debt like credit cards is costing you.”
Instead of letting all that interest drag you down, adjust your tax withholding so you’ll have more money left from your paycheck, Nisall suggested. “Make bigger debt payments as you go,” he said. “You’ll pay off your debt faster in the long run.”
3. You’re losing access to that money in an emergency
Like Rosenberg, Nisall doesn’t care for the idea of letting the government keep some of your money throughout the year. He pointed to the fact that if you need quick access to the money, it will be tied up.
“Most people don’t have what they need to cover an emergency,” said Nisall, citing a Federal Reserve report indicating that nearly half of Americans can’t come up with $400 in a pinch. “What if, instead of letting the government control that money most of the year, you had it in an emergency fund?”
With a refund of $2,925, you’re looking at setting aside $243.75 a month instead. It would be fairly simple to get your emergency fund to $400 — and then to $1,000 — if you stashed the money in a high-yield savings account instead of sending it off to Uncle Sam.
Using a planned tax refund as a forced-savings strategy?
For some consumers, a planned tax refund doubles as a forced-savings strategy, Nisall said.
“I’ve seen it plenty. From vacations to debt repayment, people think that using a tax refund to force them to save is a good idea,” he said. “Unfortunately, it’s more of a cop-out. Learn how to save on your own.”
Nisall and Rosenberg suggested setting up automatic transfers in your bank account to move away from the habit of using a tax refund as a savings strategy.
Instead of planning to have a big tax refund, it makes more sense to have a set amount of money moved regularly from your checking account to your savings account, Rosenberg said.
“It’s basically the same thing,” he said. “Only, you’re actually saving the money rather than just overpaying on your taxes.”
Both experts pointed out that the new strategy could require a mindset shift.
“A lot of people feel like having the money in the bank is too tempting for them,” said Nisall. “They think that they’ll just spend the money if the government isn’t holding on to it for them. Part of getting around that is changing the way you handle your money. Set up a system and remind yourself of your goals.”
Rosenberg said you’re better off developing new habits. “Put the money in a savings account that’s hard to get to,” he suggested. “That way, you really have to think about what you’re doing — and whether it’s worth it — before you access your savings.”
How to reduce that big tax refund
Once you decide it’s time to stop planning your finances around a big tax refund, you’ll need to make changes in the way you handle your money.
“Know how [tax] deductions work when figuring out how much your employer should withhold from your paycheck,” said Rosenberg.
You might have to fill out a new W-4 form for your employer so that you end up with what you want. For now, though, things are a bit simpler than they have been in the past, according to Rosenberg. The recently passed tax overhaul bill did away with personal exemptions, so you won’t have to worry about them while doing your taxes next time.
However, you’ll need to check if you’ve signed up for extra withholdings from your paycheck. “Many people build up their tax refunds by having their employers take out an extra $100 or $200 a month,” said Rosenberg. “You need to change your paperwork so that’s not happening.”
You don’t have to get your refund completely down to $0, though.
“It’s still better to have a small refund than owe a big amount,” said Rosenberg. “But you should aim to get your refund as close to $0 as possible. That’s when you know you’re doing things right.”