Posted by Shelly Eweka.
Remember how much of a downer it was, on your tenth birthday, when some distant relative gave you a gorgeous summer dress—only it was one size too small. How much better it would have fit you the previous summer—when you were still that size! For me, getting a tax refund is kind of like that. I don’t want a windfall from the IRS in April or May when I could’ve made much better use of that money the year before.
It’s never too late for a “paycheck checkup”
Many people see a tax refund as a kind of gift from the government. What it really means is that they overpaid the IRS during the previous tax year, in effect giving Uncle Sam a kind of interest-free loan for many months. No small-fry loan, either: The average tax refund is more than $2,800.1 The reason so many of us unwittingly “loan” the IRS money is that our default federal withholding status—the amount automatically withheld from our paycheck—is too high. Yet you can fix that by actively adjusting your withholding status at any time, simply by giving your employer a new Form W-4. You want the IRS to withhold too little than too much during the year. To find out if you’re having the right amount withheld, you can do a quick “paycheck checkup” using this IRS withholding calculator. Have your recent pay stubs and last year’s income tax return at hand.
Letting the feds withhold no more than they should will put extra money in your paycheck, month by month—money you can use to pay down debt throughout the year, or invest in your retirement fund or brokerage account.
Tailor your withholding status to fit your financial stats
That being said, you may still prefer to pay the opportunity cost of letting the IRS withhold too much, in order to avoid a potentially unpredictable tax bill in April—especially this year with the new tax reform bearing unknown fruits.
You don’t want to go in the opposite direction, where you owe the IRS more than you can afford right away, because that comes with penalties. Working with a tax planner well before Tax Day can help put you in a sweet spot where your IRS balance sheet stays as close to zero as possible. This tax year I went against the grain and withheld more than normal, because I’m not sure how the new tax laws will impact my taxable income, especially with the new cap on state, local and property taxes.
What to do with any refund you do get
If you are expecting a refund this year, I’ve always taken a repay/save/splurge approach: Use a full third of your refund to pay down debt, put a third into your emergency fund or IRA, and spend the rest on something nice for yourself. I still stand by my divvy-into-thirds doctrine with maybe one update: If you have a lot of credit card debt, use your entire refund to help pay it off. Interest rates have been at record highs, and your IRS windfall could deal a necessary pinprick to your ballooning debt.
Bottom line: As with gorgeous summer dresses, there’s no one-size-fits-all opton, except to work with a tax professional to find the most efficient withholding strategy for you.