Do you always get a fat tax refund check from Uncle Sam each year?
As exciting as it seems to receive that extra cash, you might actually be making a financial mistake by doing so.
Is it better to take enough exemptions to get a refund come tax time, or should you forgo a refund and maybe even owe a little something to the government on April 15th? And how will this decision affect your business’s finances?
Here’s a closer look at the pros and cons of receiving tax refunds.
The Trouble with Tax Refunds
Sure, most people love getting a refund check at tax time.
But in reality, when you get a refund, you’re simply getting your own money back.
However, because a refund check feels like “found money” to most of us emotionally, the tendency is to treat it carelessly and spend it on something discretionary—like a vacation, new home furnishings or some other splurge—instead of putting that capital to better use.
In addition, when you get a refund, you’re essentially lending the government your money, interest-free, instead of earning interest on that money yourself.
Besides, what if you needed that money at some point during the year to deal with an emergency expense? Wouldn’t it be better to have the money available when you need it, instead of having it “saved” for you (without a choice)?
The Alternative to Getting a Tax Refund
Instead of getting a refund, you should think about changing your tax withholding so that you get more money in your paycheck every month.
Your tax preparer or accountant can advise you on how to adjust your exemptions to get as close as possible to zero tax. (You’ll probably come out either owing just a little bit in taxes or getting a small refund.)
Make sure you’re prepared with a bit of financial cushion as tax time approaches, though, just in case you’ve estimated your tax bill incorrectly or something changes. You don’t want to end up owing too much and running into financial trouble.
Spending Your Money Wisely
Now that you’re getting more money every month instead of in a lump sum, how should you use it?
The key to making the no-refund strategy work is to not fritter away the extra income.
Instead, put that extra cash to work for you by using it to help secure your financial future.
This could mean…
- Investing in a 401(k) or another retirement plan where it’ll earn interest.
- Purchasing disability insurance to protect your future earnings in case you become disabled.
- Making sure you have enough life insurance for your family’s financial security.
- Paying down high-interest debt, like credit card debt.
- Building up an emergency savings account.
When Should You Go For the Tax Refund?
Is there ever a situation where it’s smarter to get a big tax refund than to come out even on your taxes?
If you’re not good with managing your money—you can’t trust yourself to use that extra cash in your paycheck wisely—then getting a tax refund can be a good way of forcing yourself to save money.
However, make sure not to use that tax refund as “fun money” that you throw away.
Instead, plan in advance how you’ll use it to reach financial goals like paying off a credit card, putting a chunk of money into a retirement plan, purchasing the insurance you need, or reinvesting in your business.
You can still treat yourself, though: Take 5 – 10% of the refund to spend on whatever you want, then devote the rest of it to something more important.
from Fundera Ledger https://www.fundera.com/blog/2016/06/15/pros-cons-tax-refunds/