The average American taxpayer received a tax refund of $2,815 in 2021. This increased to $3,305 in March 18, 2022, although final figures for the 2022 filing season won’t be available until the end of December. You’ve probably heard that you should change your withholding if big tax refunds have become an annual tradition for you. This would increase the size of your paychecks so you could save more money throughout the year without giving the government an interest-free loan. Getting your withholding just right can even mean taking anticipated windfalls from refundable tax credits, such as the Child Tax Credit, into consideration. But it may not be that simple. Learn what to consider when you decide on your tax withholding.
Do You Use Your Refunds Proactively or Reactively?
Emotion, not economics, is the primary driver behind financial wellbeing, according to financial advisor Tim Maurer, author of the book “Simple Money.” Some financial advisors will tell you to remove your emotions from your financial decision making. Relying solely on your feelings tends to lead to less-than-perfect choices. Maurer thinks you’re better off if you can “acknowledge [your emotions], recognize them, and plan with them in mind.” “By all means, keep your withholdings at wherever they need to be,” Maurer says if you know you’re more likely to save that big annual refund rather than save small amounts from each paycheck. This decision is best made with a hefty dose of self awareness. Ask yourself how you use the money if you usually receive a refund. You’re being proactive if you save it by making an IRA or HSA contribution. You’re being reactive if you pay down the debt you’ve accumulated throughout the year. “One of the reasons people like getting a refund is because their spending at the end of the year tends to bloat a little,” Maurer says. “They’re in debt [from the holidays] and need the refund to pay it off.”
How Would You Feel If You Had to Write the IRS a Check?
The idea of netting more per paycheck by reducing your withholding is an appealing one. But what happens if you overdo it and end up owing the government money at the end of the year instead? Heed your natural reaction if the mere thought of this scenario makes you break out in a cold sweat. Maurer says, “How much is someone actually saving in order to placate themselves emotionally? If it works for someone to receive a higher refund, then that’s fine.”
Do You Handle Small and Large Windfalls Differently?
Think about the last time you got a raise. Did your savings or your spending increase? You’re better off sticking with the refund than increasing your paycheck if getting that small bump in salary usually leads to you spending more money, but big windfalls like bonuses or refunds wind up going toward savings or debt. Financial behaviorist Jacquette M. Timmons explains that we treat small sums of money differently than we treat large ones. “We have a tendency to discount small amounts and not really appreciate how those small amounts accumulate and grow. Even saving $2.74 a day for a year adds up to $1000,” Timmons notes. “With large sums, you tend to think more of them and do more with them.” Simultaneously adjust how much you’re automatically contributing to savings if you do decide to adjust your withholding to get more in each paycheck. “You have to implement that plan immediately,” says Timmons. “That’s the key.” Otherwise, you’re likely to waste the money.
Do You Have Short-Term and Long-Term Financial Goals?
Whether you decide to reduce your withholding or keep the refunds coming, you’ll be more successful if you’ve actually made a plan for what you want to do with the money, says Timmons. “There are similarities between a tax refund and a bonus,” Timmons says. “Unless you’re intentional and purposeful, already have [a plan] for the money, and—as soon as the money hits your account—you do [implement that plan] right away, you’re probably going to waste the money.”
