What you don’t understand about tax refunds could cost you
If you’re one of the roughly 96 million Americans expecting a tax refund in early 2020, there’s a good chance you don’t understand how they work.
About half of taxpayers realize that refunds are money already paid to Uncle Sam, according to a survey of more than 1,000 taxpayers from financial services firm Credit Karma. Almost all of the remaining respondents say refunds are payments from the government, rather than reimbursements for overpayment.
Those findings highlight a lack of knowledge and a missed opportunity to shape your tax outcome, says Christina Taylor, senior manager of tax operations at Credit Karma. If you don’t understand that refunds stem from tax overpayment, you might not take steps to address that.
“For most people, a refund means they are giving the government an interest-free loan,” Taylor said.
More than half of taxpayers told the company they’d rather receive a tax refund than get more money in their paychecks. It’s easy to see why: The average refund for the 2018 tax year was $2,725, a sizable chunk of money for most workers. Credit Karma found that tax refunds represent the biggest “paycheck” of the year for 44% of those polled.
Tax refunds can offer a chance to catch up on bills, buy something special,
take a vacation or pay down debt. That $2,725 spread across 24 bimonthly paychecks is about $113 in additional income per pay stub, which may not sound as enticing as a bigger lump sum.
Enforced savings?
Some financial advocates view tax refunds as an enforced savings mechanism. By overpaying the IRS, taxpayers effectively set aside money they can put to work when they receive their refund. There’s evidence that Americans tap their refunds responsibly: Credit Karma found 51% of respondents plan to use their refunds to build their emergency savings.
However, relying on the IRS for your emergency fund isn’t as beneficial as it sounds. The IRS doesn’t pay interest on refunds. If you had instead socked away that money into a high-interest savings account – paying rates of about 2% – you’d come out further ahead over the course of a year. And unlike with a bank account, you can’t withdraw that money from the IRS if an emergency arises during the year.
When should you adjust?
Though receiving tax refunds might work for some Americans, consumers who rely on refunds to meet their necessary expenses, such as groceries or utilities, may want to rethink their strategy, Taylor says. Getting extra money in each pay period could alleviate the financial strain for those living paycheck to paycheck.
Most consumers can tweak their expected refunds by changing their withholding, which is done by revising your W-4 form with your employer. Early 2020 could be a good time to examine your tax strategies for the year, Taylor says.
Taxpayers can check their withholding through the IRS’ tax withholding estimator.