Just Say NO to Income Tax Refunds

I know you are dying to find out what could possibly be bad about your tax refund. You’ve done great things with that money! To frame the conversation about tax refunds, I first need to ask you about internet service.

Imagine you just signed up for internet service. And let’s just call the fictitious internet service provider…Bombast. You choose a package that costs $70 per month. You’re ready to activate your new service when the Bombast rep asks if you’d be interested in signing up for their budget plan. The way it works is you’ll pay $308 per month instead of $70 per month. But, if you visit the Bombast website the following year and complete their claim form, they’ll give you a $2856 refund. Would you sign up for the Bombast budget plan? I’m guessing you’d say “no.”

Yet 93 million people have accepted a deal like that. The people I’m referring to are the American taxpayers. More specifically, the three-quarters of American taxpayers who receive a federal tax refund every year. And according to the IRS, the average tax refund in 2019 was $2863.

Regardless of whether our tax refund is $2863 or some other amount, we look forward to getting it, right? Except, we shouldn’t be excited to get a tax refund. On the contrary, we should be bothered. Here’s why: a tax refund is not new money. It’s not a bonus, it’s not a windfall, it’s not a blessing. A tax refund is exactly what it’s called—a refund. The federal government is simply giving back the money we overpaid them during the previous year. In reality, our tax refund is money we loaned to the government for a year at 0% interest.

We would never loan Bombast $2863 at 0% interest. In fact, some months we gripe about paying Bombast the $70 we actually owe them! So why are we so excited to voluntarily loan our hard-earned money to the government for 12 months with no financial benefit to ourselves? If you’re like me, the story begins around adolescence.

It was 1990-something. I was a reckless teenager who had just landed a gig at the neighborhood McDonald’s where I’d be making $4.25 per hour. I was psyched! I had dreams of eventually saving up enough cash to walk into a Circuit City store and purchase an Aiwa 3-CD carousel stereo system. LOL. The 90s!

On my first day of work, my manager gave me a stack of new hire paperwork to fill out, including a federal W-4 tax withholding form. I took the W-4 home to fill it out and everything was going just fine until I got to Line 5 which asked about the “number of allowances” I was claiming. What the *cussword* does that mean?! I had no clue. So I did the thing any respectable, know-it-all teenager loathed to do: I asked my parents.

And their response was simple and stoically presented: “Just claim zero. You’ll get a refund later.” Does that sound familiar to you? I didn’t understand what “claiming zero” meant, but getting a refund sounded great to my teenage brain. I had never gotten a refund before. Maybe the refund would be enough to buy that Aiwa stereo! And just like that, I was all in on the refund idea.

I filled out the W-4 and claimed zero allowances as instructed. When I filled out the W-4 for my next part-time gig in college, I again claimed zero allowances. When I filled out the W-4 for my first professional gig after college, I again claimed zero allowances. And exactly as my parents promised, I got some kind of refund every year when I filed my taxes. And eventually, I got that 3-CD carousel stereo too. Life was good!

To avoid a long explanation about tax withholding, here’s the cliff notes version of what my parents told me to do for that first job: Have my employer withhold the maximum amount of federal income tax from my paycheck—even though it was 100% certain I wouldn’t owe any federal income tax at the time—and then file for a refund of that money the following year.

And so that’s what I did. It became my regular practice to have my employer withhold the highest amount of tax from my paycheck and then file for a refund. I was well into adulthood before I realized I didn’t have to overpay my taxes. Instead of having extra money withheld from every paycheck for taxes I don’t owe, I could adjust my withholding allowance and keep that money in my own hands. And I could put that money in my retirement savings account…or take that dance class…or get my car fixed…or hey, I could even buy that 200-CD changer that just went on clearance at Circuit City!

What does all this have to do with you? Every time you started a new job, you too filled out a Form W-4 and wrote down the number of allowances you wanted to claim which then determined how much federal tax was withheld from every paycheck you received from that employer. You still with me so far? And if you’ve ever received a federal tax refund, it means you—like most Americans—overpaid your taxes the previous year. It also means you were coming up short on every paycheck. If, for example, your tax refund this year is $2900 and you get paid twice per month, that means you could have been taking home $120 more per paycheck for all of last year instead of waiting around for your refund this year. Would you have been okay if every paycheck had been $120 higher last year? If so, here’s what you can do now.

But hang on a sec. Before I go any further, I have to say this. I am not an accountant or a tax professional—I’ve never even played one on TV. The views expressed in this post are my opinion based on my own reading and personal experience. This is not tax advice. Each person’s tax circumstances are unique and can dramatically change from one tax period to the next. So before you do anything, please do your own reading (other than this blog post), talk with a trusted tax professional, ask Siri—whatever your thing is.

If you received a sizable tax refund last year and would prefer to keep more of your earnings, you’re in luck! The IRS released a new version of Form W-4 in 2020 and they’ve removed the allowances question. You still have to do a little bit of reading to complete Form W-4 correctly, but the questions are easier now. And in theory, at least, completing the new Form W-4 should help your employer withhold the correct amount of federal income tax over the course of the entire year. That means you won’t be getting a refund check. But it also means you won’t be overpaying your taxes. And just like with every other expense, that’s the goal: to pay what you owe—no more and no less.

Let me leave you with one last thought. As tax season goes on, you’re going to see and hear plenty of stuff that will have you second-guessing your decision. The mass-market tax prep companies will flood the airwaves promising to get you “the biggest tax refund…guaranteed.” Well-intentioned friends and family members will be boasting about their refunds and how they plan to spend it. It will be tempting to dismiss everything you’ve read here, continue overpaying your taxes, and continue getting a refund. I get it—I really do. But I’ve found that when it comes to managing our dollars, the contrarian approach usually makes the most sense.

GTall signing off.