My Tax Refund – Why Is It So Small?
This time of year, W-2 forms are coming in, shoe-boxes are coming out and kitchen tables are disappearing under a pile of documents. It’s tax time, and the most common set of questions we hear revolve around the same issue: Why is my tax refund so small? How can I make it bigger? While we are not tax professionals, here are some observations we’ve had while serving our members over the years. You may want to discuss them in further detail with your tax advisor.
Question: Why is my refund so small?
Answer: There’s no secret to withholding. You tell the IRS factors about your life, your employer holds money back to “guess” at how much you’ll pay in income taxes, and then whatever has been withheld is paid to the IRS for covering your annual income tax burden. If, in fact, you’ve withheld more during the year than you need to pay, the IRS will pay you back any extra income you’ve withheld.
If your tax refund is smaller than you expect, then you didn’t withhold enough money to cover your tax bill. If the amount is surprising because it doesn’t look like last year’s refund, then you probably had something different happen this year. Did you pick up extra income? Did a child move out? Did you stop paying the interest on your mortgage or student loans? Knowing this, if you’re looking for a reason why your refund was smaller, start with the changes in your life.
If you still can’t figure it out, look at how much you made this year as well as your total withholding. If you made significantly more than last year while withholding the same amount, that could be the reason. If you want better, more specific answers, take your information to a tax preparation professional.
Question: So, should I withhold more?
Answer: We hear this one a lot. Many of our members were raised on “the IRS savings plan,” particularly if they came from poorer or lower middle-class backgrounds. Families that had trouble getting ahead would plan on tax refunds for a once-a-year spending spree. Now, as the children of those families have grown up, they want to have that type of spree as well.
It’s not a good idea to withhold more money so you can have a bigger refund. In fact, it’s about the worst investment you can make, because you get paid no interest on it. Your money will even lose value due to inflation while the government holds it, so it’s like you paid someone for the privilege of not accessing your money while it earned zero interest. Imagine a free checking and savings account, except the exact opposite in every way: It’s not free, you can’t access it like a checking account, and you don’t earn interest on it like a savings account. Its a free checking and savings account you set up for someone else.
Question: How can I get more money back?
Answer: The obvious way to get more money back on your tax refund is to find more deductions or withhold more during the year. However, there are other ways to make tax time more profitable.
Imagine that, instead of withholding an extra $100 every month, you invested it in a savings certificate, money market, or Christmas club account. Over the course of the year, you’d accumulate $1,200 in principle, just like you’d have an extra $1,200 coming from the IRS. In other words, this method is just as good as the IRS savings plan: If something crazy happens on your tax return or you have some money to avoid a big tax bill, you can have a big annual spending spree.
But it’s better than withholding for a variety of reasons. First, you can access it if you’re putting that money into a money market or other savings program. Second, your money will be protected from inflation, and then it will grow. Earnings on different programs vary based upon what you choose to invest in, along with other factors. But even earning a couple of percentage points above inflation could lead to another $100 in your pocket on top of the principle, and save you $100 that you would have lost to inflation. $200 isn’t chump change, particularly on a modest investment, and it could even be more depending upon how much you invest and the program you choose. Even if you don’t earn much, though, it’s still better than giving that money away.
Even better, you can use that money to double dip. If you withhold that extra $100 every month, then deposit it into a tax-exempt college or retirement savings funds, you can have a big payday while building deductions for next year, so you’ll get even more back. Obviously, your specific situation will vary and there are limits to how much you can put into each of your tax-exempt accounts, but if you’re interested in starting the snowball effect of compound interest, tax deductions and long-term savings, there is no better time than the present!