Get ahead and quit the tax refund cycle
Many taxpayers think getting a federal tax refund is a big deal. They look forward to it all year.
It’s the largest lump sum many people receive, according to the American Tax and Financial Center at TurboTax, the tax software company.
Last year, the average federal tax refund was about $2,800, about $100 less than in 2011, according to the Internal Revenue Service. In 2010, the average refund was about $3,000.
Typically, you pay your federal taxes by having a portion withheld from your pay. If too much is withheld, you get a refund. But guess what? In order to get that lump sum, you lent your money to the government with no interest.
Still, a majority of respondents in an online poll said they intentionally have too much money withheld from their pay so that they can receive a refund, according to the National Foundation for Credit Counseling, which conducted the survey.
“Many people say that they can’t find a way to consistently save other than to short themselves through their payroll withholding,” said Gail Cunningham, spokeswoman for the NFCC. “That is indeed forced saving in the truest sense of the word.”
When it comes to what to do with the refund, most people do the smart thing — they use it to pay down debt or put it away for other uses. For others, it’s the little extra they need to stretch their paychecks at the beginning of the year.
Forty-two percent of taxpayers who file their returns early use the funds to cover rent, food and utilities, the TurboTax survey found.
I’ve encouraged people to quit relying on a tax refund. Yet the lesson seems lost on so many.
Many intentionally get a refund because they don’t feel they are disciplined enough to save on their own. And if the alternative is that you won’t save, then go ahead and do what works for you. At least you’re putting that refund to good use when you get it.
But consider this. Your forced savings plan may be costing more than you realize.
We know that many folks live paycheck to paycheck, which often means not having enough to cover all their expenses. Some bills go unpaid or are paid late. Or perhaps you are making only the minimum payment on your credit cards because there aren’t any extra funds to pay them down faster.
“Why continue in this financially self-defeating cycle when a solution is so readily available?” Cunningham said.
“An incredible amount of damage is done to credit reports and scores each month due to consumers not being able to pay at least the minimum amount due, or paying it late,” she said.
“And that’s not even counting the amount of interest and late fees tacked on to existing balances.”
So let us make the case against getting a refund.
For the last several years, the average income tax refund has been just under $3,000, which works out to about $250 a month. Here’s an illustration Cunningham came up with to show the difference an extra $250 per month can make.
Let’s say you have a credit card balance of $5,000 with an APR of 14 percent. Your minimum monthly payment is 2.5 percent of the balance, or $125. If you make no further charges and no fees are added to the balance, it will take you 55 months of making a consistent payment of $125 to pay off the debt.
In that amount of time, you will have paid a total of $6,774 on that $5,000 debt, meaning about $1,774 went to interest.
Using the credit card calculator at Bankrate.com that shows the “true cost of paying the minimum,” it will take you 213 months to get rid of your debt if you make only the minimum required payment of 2.5 percent.
In that time, you will pay $4,063 in interest. Even if you plan on using the lump-sum refund to pay down debt, you’re still accumulating interest while you wait on your money from the IRS.
But what if you adjust your W-4 withholding so you don’t get a refund? The W-4 has a worksheet to help you figure out how many personal allowances to take, based on what tax deductions or credits you expect to claim.
You can also use the IRS online withholding calculator at www.irs.gov.
Using the same example, you could add to the steady $125 credit card payment the extra $250, for a total monthly payment on the credit card debt of $375.
If no further charges are added to the balance, it will take 15 months to pay off the debt. Further, the total cost of the credit will be $5,467, for a savings of about $1,300.
“Same debt, same APR, but a very different outcome, all achieved by using your own money each month instead of once per year,” Cunningham said.
I think that makes a good case to quit getting a tax refund, don’t you?
Michelle Singletary is a financial columnist for The Washington Post.