Why You Don’t Want a Big Tax Refund

With tax season upon us, it may be time to revisit and review your W-4. The form, which you are asked to fill out upon starting a new job, provides your employer with the information they need to withhold taxes from your paycheck. If the form is incorrectly filled out or outdated, you could be missing out on money that could otherwise be used for investing.

Completing Your W-4 Incorrectly Could Benefit Uncle Sam Immensely

When completing their W-4, many people fill it out in a manner that results in more taxes being withheld from their paycheck than is strictly necessary—the general theory being that, by claiming fewer withholdings on the form, they’ll get a larger refund when they file their taxes for the calendar year. You might claim to be single when you’re actually married, or you could have multiple children and only list one as a withholding.

Come April 15, you may be happy that you’ve gotten a big tax refund, but in reality, you’ve essentially provided the Internal Revenue Service (IRS) with an interest-free loan for the year. If the idea of giving Uncle Sam an interest-free loan sounds unappealing, it may be time to recognize that you can utilize your W-4 as a powerful wealth-building tool. By reducing the amount of taxes you are having withheld, you can make more money available in your paycheck to invest elsewhere, like your 401(k).

Why Minimize Your Tax Refund?

Everybody loves the idea of getting a check in the mail, so the IRS providing us a tax refund every year may sound nice. The fact of the matter is, there is a significant opportunity cost when you allow the IRS to hold on to the money you withhold from your paychecks. For many, a more strategic option would be to redirect those dollars in a 401(k) account. (For related reading, see: 6 Tax Myths Everyone Should Know.)

A traditional 401(k) deposit through your employer comes from your pre-tax dollars, which makes those contributions tax advantaged. Many employers will match a percentage of what their employees deposit. Therefore, if you increase your retirement account deposit, you will actually be reducing your total tax burden and improving your retirement savings. Over time, the additional contributions that you redirect will benefit from any growth that may take place within those accounts. Over the course of 20-30 years, redirecting these dollars to your retirement contributions may result in a significant amount of retirement assets.

Review Your W-4 Regularly

Most people fill out a W-4 form upon getting hired at a new job and never give it another thought. While some people fill out the form purposely to maximize their refund, others simply have not updated it to accurately reflect their current living or financial situation. To ensure that you’re not taking out too much or too little from your paycheck, it’s important to revisit your W-4 annually and adjust it according to your current salary and lifestyle. (For related reading, see: When You Should Change Your Withholding Tax.)

Specific events that would call for making changes to your form would be:

  • You Have a Change in Marital Status: If you get married or divorced or are widowed, you may want to change your withholding status.
  • You Get a Raise: If you get a raise, you may want to consider adjusting your withholding so you can deposit into your 401(k) account.
  • You’re Approaching Retirement: If you are within five years of retirement, it may be worth considering how you are having your taxes withheld so you can maximize your retirement savings.
  • You Receive a Large Tax Refund: While this might not be a specific life event, it is likely the number one reason to review your W-4.

For those who have more than one job, carefully consider each W-4 form you have to fill out. In some cases, you may want to have more money withheld from a second job than you would if you were only working one job. For example, you might have a day job that brings in a salary of $40,000 and a second job as a weekend employee at Starbucks that only brings in $2,000. When filling out your W-4 for Starbucks, you’ll want to withhold at a higher rate because it’s only taxing the $2,000 you make there even though, in reality, your total gross income is $42,000.

As the tax refunds roll in for 2017, realize what you could be doing with that money instead. There is little to be gained by giving the IRS access to an interest-free loan when you could be using your extra money to fund your retirement account. Of course, we know that many people view their tax refund as a vacation fund. However, if you consider retirement an extended vacation, by redirecting that money to a retirement account, you can still have your vacation fund while growing your savings. (For related reading, see: Tax Withholding: Good for Government, Bad for Taxpayers.)