According to a Credit Karma survey, 44 percent of those surveyed responded that their biggest paycheck of the year is their income tax refund. While many people use money from tax refunds to pay off debt or to increase emergency savings, 32 percent of those who participated in the survey said their refunds would be used to pay for necessities like rent and groceries.
So one would think that a large tax refund is a cause for celebration. However, what that really means is that you overpaid on your taxes, allowing the US Government to have interest-free use of your money for the year. And that does not sound so much like a cause for celebration.
What Is Income Tax?
Investopedia states that:
The term income tax refers to a type of tax that governments impose on income generated by businesses and individuals within their jurisdiction. By law, taxpayers must file an income tax return annually to determine their tax obligations.
Income taxes are a source of revenue for governments. They are used to fund public services, pay government obligations, and provide goods for citizens.
Personal income tax is a type of income tax that is levied on an individual’s wages, salaries, and other types of income.
Who Is Required to File An Income Tax Return?
From usa.gov:
You may not have to file a federal income tax return if your income is below a certain amount. But, you must file a tax return to claim a refundable tax credit or refund for withheld income tax.
This applies to United States citizens working in both the U.S. and abroad, as well as to citizens of other countries living and working in the U.S.
The IRS website (irs.gov) lists more details on what those income levels are, as well as other specifics related to deductions, filing status, etc.
Tax Year 2020 Numbers
For the 2020 tax year, there were over 240 million income tax returns filed, and 125.3 million refunds issued so far for a combined total of $317.7 billion. The average amount of those tax returns was $2,827.
What Determines How Much Tax Is Withheld From My Paycheck?
One of the documents you file with your employer when you begin a job is a W-4. The information you provide on this document is used, along with various other documents and charts, to determine how much is withheld from your paycheck each pay period for taxes. However, many individuals are unaware that you can change your selections on this form as your circumstances change.
You can choose to have your employer hold out more for taxes if you want to receive a refund, or less if you would rather have more money coming home in each paycheck. For example, with the average income tax refund for the tax year 2020 being $2,827, if that money was not withheld for taxes, that would equal an average of $235.58 additional coming home each month. For those who indicated they would use their tax refund to pay for essentials, that could make a huge difference monthly.
How Do I Know How Much I Should Withhold?
When you remember that any money you receive as a tax refund is just your own money that you allowed the government to use interest-free, the ideal situation would be to hit that balance of neither owing nor receiving any money when you file your tax return.
Determining how much to have withheld from your paycheck to make that happen can become complicated. The irs.gov website has a withholding calculator you can use to determine ideal withholding amounts by inputting your specific information. However, consulting with a company like Melanin Tax Solutions can help you to better understand all of the factors that impact your tax return, and what other options are available for improving your tax situation.
Reasons to Avoid Receiving a Large Tax Return
The number one reason to avoid receiving a large tax return is that your money could be working for you and your family during the year rather than providing interest-free funds for the government. Anything you can do with that amount of money in a lump sum as an income tax refund could be multiplied if used properly in smaller amounts throughout the year.
You may be able to make a sizeable payment toward credit card debt with your income tax refund, however, regular extra payments toward the principal amount of that debt would eliminate excess interest on a larger balance. This would amount to an even greater decrease in your overall debt.
And again, for those relying on tax refunds to pay essentials like rent and groceries, having more money coming home with each paycheck could prevent those needs from reaching a critical point.
In addition, if you are more financially sound and can do without applying those funds to essential needs or to lower your debt, you can always invest those funds yourself and increase the financial benefit.
Conclusion
Even though it may feel like a windfall to receive that large income tax refund check, it really is not a cause for celebration. Understanding what options are available to you is the first step to maximizing the potential of your income and making your money work harder for you rather than the government.
Contact Melanin Tax Solutions for a consultation and allow us to walk you through options that can benefit you and your family.