Receiving notice that a large federal or state tax refund is coming back to you can be a relief and feel good in the moment, but it’s important to remember that it is a refund of the overpayment, or over-withholding of federal or state income taxes from your earned income. Although many taxpayers prefer to overpay as it is a means of forced savings, it may be hurting their long-term financial best interest. The overpayment of taxes is essentially an interest-free loan to the government. Considering the inefficiencies, poor accountability of government spending, and not receiving interest on the overpayment of your taxes, it would be better for most people to either receive a nominal refund or have a nominal payment into the government at the end of the year. The benefit of either is you have full use and control of the ability to save, invest, or spend those dollars versus assuming debt to meet income needs. Do you really want to keep that money in your pocket throughout the year rather than give the government an interest free loan?
What if you could defer those dollars pre-tax into an IRA or employer sponsored retirement plan that has a matching contribution? Or, could you receive the income net of taxes to meet your living expenses, or avoid accruing credit card debt?
There are two options you may want to consider. Consider using the Federal Tax Withholding Calculator that can be found on the IRS.gov website – Tax Withholding Estimator | Internal Revenue Service, or seek the guidance of an accountant or CPA to estimate your federal and state withholdings to ensure you are meeting your estimated withholding requirements of your earned income. Within this tool there are options for filling in the amount of pre-tax contributions to retirement accounts and Health Savings Accounts which will lower your taxable income overall. You can play around with this tool to determine how different contribution amounts affect your estimated withholding.
The IRS recommends that you complete a new form W-4 every year or whenever life significantly changes to evaluate your withholding amount and to avoid having a large tax bill at the end of the season. The W-4 will also help figure out what deductions you can take. If you have questions about this process, ask your CPA/tax professional for help. W-4 Calculator | IRS Tax Withholding Calculator 2024-2025 | TurboTax This calculator from TurboTax can help you figure out the information you will need to fill out your W-4.
The best way to ensure that you are withholding the proper amount of taxes throughout the year is to work with a CPA. Proactive tax planning can be beneficial especially to those with complex income situations. If you are continually owing big money after tax season that could mean you are not withholding enough throughout the year. Generally, the closer you are to zero the better at the end of tax season the better.
If you do receive a large tax refund, then it’s important to be dutiful and think about making a financial decision that moves you in the right direction. You have just received your own money back after giving it to the government, consider using this to pay down a debt, create an emergency fund, save it for retirement, or work towards one of your other financial goals. The emotional response to a large cash infusion can make you feel like you have won a prize, and it might feel easier to spend the refund frivolously. However, having the clarity to cut through the emotion and stick to the plan you have set for yourself will have your future-self thanking you.
Just like all other aspects of your financial health the best way to stay on top of taxes is through planning.
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