The following is a guest post from Derek Clark who recently launched Christian Common Cents: a blog about common sense solutions to financial problems using biblical principles as a guide. He is also a big fan of Dave Ramsey and is giving away 3 copies of the Total Money Makeover.
Lots of people look forward to receiving a big tax refund each year. According to the IRS, the average tax refund will be $2,800 this year. That is over $230 a month that everyone is lending to the government interest free. If you are following Dave Ramsey’s plan like I am, that is a lot of money that could be going towards your debt snowball or emergency fund.
If you are still in debt and looking to get out, an extra $230 a month can really help. I know I want can’t wait scream “I’M DEBT FREE” and if I can do that even a few weeks soon I will do it. I got married last year, so I wasn’t entirely sure how my taxes were going to be effected. After I filed my taxes and realized we were getting about $2,500 back, I changed my withholding so that I won’t loan Uncle Sam as much money this year. The extra money each month is going straight to my wife’s college loans, and we plan on being debt free in June!
But I’ll Just Blow the Extra Money
Some people say they can’t be trusted with the extra money each month. They will just blow it and not have anything to show for it. So they loan it to Uncle Sam and then when they get it back in one big chunk they can pay off debt then, fix up the house, or go on vacation. If you want to be debt free, you have to be more disciplined than that. You need to spend every dollar on paper on purpose with your budget before it happens each month. Then you have to actually follow through with it. If you are having trouble budgeting and actually sticking to it, try using the envelope system.
If you don’t think you could save the money and you’d rather have it come out automatically, you can do that yourself. You can set up automatic transfers to happen each month, or even have your HR direct deposit it for you. It is better to have the money taken from your check yourself and put into a separate savings account rather than giving it to the government to hold for you. That way you can earn interest on it, pay off your debt as soon as possible.
If you still have debt, the interest you pay each month is a huge drain. Take the extra money that you are sending to the government and pay it directly on that credit card you are trying to pay down. The extra money will all go directly to the principal saving you significant amounts of interest in the long run. You’ll be glad you did.
{ 17 comments… read them below or add one }
At the risk of sounding “tin-foil hattish,” I offer the following…
It’s not just that you’re giving the government an interest-free loan, you also run the risk that the money won’t be there when you want it back. Vouchers, refunds as savings bonds redeemable after 2-3 years, that sort of thing. Not real likely, but a risk you don’t have to take.
In addition, the IRS has no problem when you increase withholding (lowering your W-4 allowances) but if you increase your allowances it can bring scrutiny (especially if you have 10+ allowances due to charitable giving, interest, etc).
This refund risk and lopsided W-4 sensitivity will only get worse, IMO, suggesting that now is the time to make sure you don’t overwithhold at either the state or federal level. Especially if you live in CA…
Thanks for the comment. gn brings up a good point. There are actually quite a few states that are “delaying” tax refunds because they flat out don’t have the money. I have very little desire to get an IOU in the mail.
The average tax refund in America is about $2,300. (according to crown.org). That’s almost $200 a month that taxpayers are letting the IRS have all year long for free. It’s a wiser use of your money to have that $50 a week in your budget to use for saving, giving, and paying off debt.
I’ve increased our W-4 exemptions to the point of being 2x the number in our family in an attempt to decrease our refund — better to have that money in hand that wait until post-April 15 to get it back — and I had less than $40 in federal taxes withheld in ’09. Did our federal taxes last night & our refund this year is $1700+. I itemize our deductions and this is the 1st year that I can remember the standard deduction was more than the itemized — by about $150. Don’t know what to do to decrease our potential refund in the future; suggestions? Now we will end up owing the state some cash; haven’t done that one yet, but in the past it’s been in the $250 ballpark.
Oops, my bad, our itemized deductions were greater again this year than the standard.
I tend to feel differently about a refund than most. I know you are giving the government a loan and all that, which is true. However, if that is way some people choose to save then good for them. I have a friend at work who gets a decent refund every year and that is how he goes on a summer vacation with his kids. Isn’t that better than putting the trip on a credit card and then paying it off all year? He knows it is not the best method for saving, but at least its saving. I cannot disagree with him.
With all due respect to my friends at TurboTax (Disclaimer – I love the product and guest post there) it’s not “about the refund” for me. In my ideal situation, I have a penalty for underpayment that goes to zero when I enter the last donation amount. Got that?
We will owe about $3K but with no penalty, so it was an interest free loan from Uncle Sam to us. Of course this is a position to the extreme opposite of those who use the refund as a savings account. In the same approach others use to save for vacation, I know that we’ll have bonus money coming in from
the first quarter of the year.
As I’ve come to understand, it’s about one’s emotion and discipline. If this is the only way for them to save, and they can’t set up an auto-deduction or other type of automatic savings, then I’ll concede “whatever works.”
The official advice I offer, however, is if your refund/tax owed is more than the amount that one change in exemption adjust would take care of, you should make that change. If you’ll permit a plug for a fellow blogger, Jeff at Deliver Away Debt wrote an excellent tutorial on how to adjust withholdings at http://deliverawaydebt.com/taxes/how-to-adjust-tax-withholdings/
My husband has finally come around on agreeing we should work toward a small refund next year, and it took finding out the Feds will be handing out some sort of bond next year instead of giving back our cash. Though credit cards aren’t allowed to have opt-out programs anymore, that’s what the Fed has put into place. We’re using this year’s refund to pay down debt now, and will use the increased income throughout 2010 to pay down debt as it comes up. We only started the DR plan in January, but already we can see great gains and life is so much less stressful with a budget that plans instead of tracks money!
Thanks for all the great comments. I meant to mention the possibility of getting savings bonds as a refund in future. Definitely not the route I want to take. The more I think about it the more I want to have a tax bill of zero. The extra money each month is a nice bonus too
There are people out there who just can’t keep money in their possession – if they have it, they spend it. For those folks, I don’t think it’s a bad idea to overpay taxes as it’s a weird type of savings plan for them. As for the interest lost overpaying taxes as opposed to putting the money in savings, savings rates are so low right now that it makes precious little difference.
One thing is for sure, the interest I pay for not using that tax money to pay down debt does make a difference. If I’d put $300/month against my debt last year instead of overpaying the government by $3600, I’ve have saved a lot in reduced interest to credit card companies. Of course, this is the new view we have since we decided to “live like no one else”…
@Lara
I agree that interest rates are mostly negligible right now, but as Julie points out for people that have 20+% credit card debt they could be paying it is a big difference. Alternately, if you are out of debt you could invest it and not just put it in a savings account.
Being in a separate savings account is still preferable to giving it to the government as you have it in case of emergency. One thing that Dave Ramsey suggests is putting it into an account that is hard to access. For example, one of my savings accounts won’t let me take money out online. I have to actually go to the bank to get at it. This is perfect for those types of people who just think they will spend anything they have. Have it automatically put in an account that you can’t easily touch and it is very similar to giving it to the gov’t. Except you still have it if you really do need it.
The option to receive your refund as a savings bond is available this year, there has been no talk that I have seen of mandating this (although some conspiracy minded folks will say otherwise).
I’ll get back a healthy refund this year, but my pay is variable and in a different year I would just about break even. I certainly could have used the cash all along, but short of doing my taxes quarterly, how can I estimate a W-4 so that I don’t get a large refund?
@Randy
With a variable income it is very difficult. Generally if someone gets a similar refund each year they can change their withholding accordingly. With a variable income you would probably have to either go with an average of your past few years or just go ahead and give the government extra some money. It isn’t the end of the world, and it is probably better than having to pay a huge bill at the end of the year.
Absolutely against! Why give it to the government? Sometimes people say to me that they wouldn’t have the discipline to save it…then have the amount you were paying in taxes from your check (if you have direct deposit) go automatically into another account. You won’t even see it hit your regular bank account and you can be the one in control of that cash if an emergency were to hit. Just talk to your HR department to have that set up!
Actually, if you’re in debt you can under pay your taxes, and borrow money from the IRS at low rates and buy time to pay high-interest credit card debt while repaying the IRS. File a Form 9465 along with your tax form to request an installment payment plan. You can set your own terms and approval us generally automatic. You’ll be charged a setup fee of $105 ($52 if you agree to automatic withdrawls from your bank account) and will be charged a low interest rate (currently .583% per month or about 7.25% per year). With careful planning, this can be an effective strategy that will meet your tax obligations and free up cash to make progress on your credit card debt.
@ThriftyMan
While that is true, I wouldn’t suggest it for the simple reason that the government is a very tough creditor. You do not want to owe the IRS money for any reason. If something goes wrong you are in way more trouble than if something goes wrong paying off the credit card companies (banks).