It’s the start of tax season, and many of my friends are basking in the glow of their tax refund.
“I’m getting $3,000 back! Hooray! I love getting a tax refund!”
Hmmm. That's questionable.
In many cases, getting tax refund from the government can cost you more than adjusting your tax withholdings so that you don't get a refund.
If you’re getting a refund, you’ve been overpaying your taxes. This means you’re giving the government a zero-interest loan.
This can be a bad idea for everyone, and it’s especially dicey for people who carry debt.
If you have debt – such as a student loan, a car payment, a credit card balance, or even a mortgage – you’re paying interest on that debt. But you’re simultaneously giving Uncle Sam an interest-free loan.
How much is this costing you? Let’s look at a hypothetical scenario:
In 2010, Sally gets a tax refund of $3,000. This means she over-paid her taxes by $250 per month. She adjusts her tax settings so that this will no longer happen.
Sally now receives an extra $250 per month in her paycheck.
In 2011, Sally takes out a $15,000 car loan at an 8 percent interest rate. Her payments are $304 per month for 60 months.
Sally applies that extra $250 per month towards her car loan, making a total monthly payment of $554.
Keep Sally’s story in the back of your mind. Now, let’s imagine a second scenario:
In 2011, John takes out a $15,000 car loan at an 8 percent interest rate. His payments are $304 per month for 60 months – identical to Sally’s loan.
One year later, John gets a tax refund of $3,000 and uses the entire refund to make an extra payment towards his car loan.
John makes an extra $3,000 payment towards his car every year.
Who saves more money, Sally or John?
Sally’s shaves $1,652 off her interest payments. Plus, her car will be paid off within 30 months, instead of 60 months.
John shaves only $1,342 off his interest payments. His car gets paid off after 36 months.
In other words: John loses $300 and spends an extra 6 months paying off his car, compared to Sally.
Sally cuts the length of her loan in half by applying an extra $250 per month towards her car loan instead of over-paying her taxes.
John loses $300 by giving the government an interest-free loan while simultaneously paying interest on his debt.
If you want to stop over-paying your taxes, here are a few tips:
#1: Talk to your professional tax advisor to find out how to get fewer dollars taken out of your paycheck upfront. Your tax advisor will tailor a plan that’s customized to your situation.
#2: Calculate the difference in your take-home pay after you adjust your tax withholdings. For example: you used to bring home $1,500 per paycheck, and now you bring home $1,600 per paycheck. This means you bring home an extra $100 per paycheck.
#3: Set up an automatic transfer of that amount – in this example, $100 – into a savings account. Use it to bolster your emergency fund, or use it to pay off debt.
It's important to note that this plan works best if you set up a weekly or monthly automatic transfer for the "extra" money in your paycheck. If you end up wasting that money on trinkets, you won't be any closer to repaying debt.