Getting a tax refund feels like a welcome boon. At the very least, it seems like a nice cash reward for the estimated nine hours it takes the average individual taxpayer to wade through their W-2 and 1040 forms. And it’s not an insignificant amount of cash: The average 2022 tax year refund is $2,933, according to the internal revenue service (IRS). It’s not an amount to be sneezed at.
It’s also a sum of money that can go quite a way toward building some healthier financial habits, especially when it comes to building your emergency savings or retirement nest egg. But before you get to the point where you spend your refund, there are two big money mistakes you want to avoid.
A financial advisor can help you with a realistic financial plan to keep you on track.
Mistake No.1: Getting a Refund Isn’t 100% Ideal
This may come as a surprise to some, but getting a refund isn’t 100% ideal. At first glance, getting a refund means that you’ve given Uncle Sam a tax-free loan of a couple thousand bucks for more than 15 months – without interest. That’s money that you could’ve gotten in your regular paycheck, to use as you see fit all year. That’s Mistake No. 1.
Caveat For Receiving a Refund
Mistake No. 1 isn’t quite so bad if you grab that refund check and run directly to the bank to put that money into savings. Or, even better, you put it into your investments. Sure, you missed the opportunity for some compound earnings. But at least you’ve eventually put the money to good use.
Fixing Mistake No.1
Fixing Mistake No. 1 is easy if you use the estimated withholding calculator on the IRS website. If you enter your correct information, it gives you a very good estimate of how much tax you’ll owe at the end of the year. And it will show how to fill out your W-4 withholding form to send the IRS just that exact amount during the year.
The cash you’d get in a refund will now show up in each paycheck. That seems like a good outcome except that this is where mistake No. 2 crops up.
Mistake No.1 Can Lead to Mistake No.2
What is the problem with your refund showing up in each paycheck? Well, that extra money gets thrown into the general checking account. And now it’s likely going to be consumed with rent, car payments, grocery purchases and all the other costs of day-to-day living.
If you’re the kind of person who saved or invested your refund check, you’re now worse off in that scenario. And that’s because the money that would have been refunded in a lump sum to be used wisely is now vanishing bit by bit amid your regular spending.
How to Fix Mistake No.2
Fixing Mistake No. 2 is easy. All you need to do is to have that extra money automatically deposited to a savings or investment account. If you’re saving the money for your emergency fund in a separate savings account, such as an online account that pays at least a bit of interest, that is a good choice. You can also have the money automatically deposited. So it’s safe and you can access it quickly in a crisis.
If you’re investing the money, then you simply add it to your 401(k) transfer at work. Or, you can use it towards an individual retirement account (IRA). Or you can use a Roth IRA. You can open a Roth IRA online with one of several big mutual funds or brokerages. If you’re new to investing, you can put the money into an index fund.
Bottom Line
Whatever type of account you choose, whether it’s in a retirement account, mutual fund or index fund, the money that would have been sitting in Uncle Sam’s pocket for up to 15 months is now working for you, either to cover a financial emergency or to build compound earnings for retirement. It may not be as exciting as getting a big annual refund check, but it will increase your overall financial security.
Tips for Maximizing Your Tax Savings
- Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area. And you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- When you’re filing your taxes, a tax filing service can make things easier. They can take a lot of the confusion out of the process for you. And they can help you file a more accurate tax return. They can also help you find deductions or exemptions that you wouldn’t have known about on your own. Popular software choices include TurboTax and H&R Block.
- If you find that you’re regularly receiving large tax refunds, this may mean that you’re paying too much in taxes in the first place. In that case, you may want to adjust the withholding amounts on your W-4. This is so you can keep more money throughout the course of the year. Big refunds are exciting, but why give the IRS a free loan?
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