Tax Refunds and the W-4

With tax season on hand, it’s a good idea to take a bit of time to think about your own finances and tax planning.  It’s funny to me that every April retailers ramp up the ad campaign trying to get people to splurge their tax refund on a bunch of stuff that they might otherwise not be able to buy.  “Hey, you’re about to get a thousand bucks from the government, come buy that big flat screen TV you’ve always wanted.”  They try to make you think that your tax refund is a bonus check that you should spend on some great luxury good.

The reality is that in most cases, your tax refund contains tax dollars that you’ve loaned to the government (interest-free, of course) over the course of the year and every spring they are kind enough to pay you back.  Now this is not always the case, as lots of people get increased refunds because of tax credits (popular ones include child credits, earned income credits, or various education credits) which really are basically free credits from the government, but in lots of cases, you are getting money back as a refund because you have paid more taxes over the course of the year than you owe. 

Now let’s address a basic economic principle. The Time Value of Money.  If I offered to give you $1,000 today or $1,000 a year from now, which would you choose?  Your grandma answers this question every time she tells you that in her day, she could see a movie for a nickel.  What she is telling you is that a nickel was worth a WHOLE lot more to her on that day in 1929 than it is today. The same applies to your $1,000. Not only is your money losing value over the year because of inflation, but you are losing the opportunity to save/invest it and earn interest on it, all while handing those opportunities over to the IRS. 

On a side note, don’t think the IRS doesn’t know this.  Pretend like the IRS collected $200 extra dollars in tax revenue from 50 million Americans last year.  They will have to refund each person this $200, of course, but not until you file your taxes in six months.  During those six months, they earn a measly 1% interest on that money.  That’s $100,000,000 in interest income for the IRS, and you don’t see a penny of that, you just get your original $200 back. 

Now to the point.  Don’t loan the IRS money for the year.  As fun as it is to get your big check every April, that money could have meant more dollars from each paycheck last year because you were paying too much tax.

How do you do this, you ask?  That is where we finally get to the W-4.  When you began your job you filled out an IRS form called a W-4.  This form is the basis for how much taxes are taken out of each paycheck.  If you are getting a big refund every year (and not because of tax credits), it is high time you review this form and review how many exemptions you have claimed.  The idea for tax planning is that you want to be all square with Uncle Sam every spring. You want to have paid your taxes like Goldilocks, just right.  Not too much, not too little.  Of course this will never really happen, so if you are a couple hundred dollars in either direction, no big deal.  What you don’t want is to be getting back boat loads of money each year.  You certainly don’t want to be paying money either (because not enough taxes were taken out), so the best way to make sure you are filling this form out correctly is to use the withholding calculator and/or manual worksheet that the IRS provides on its website to help you fill out this form.  The withholding calculator is a good tool where you can enter your actual income and tax situation and get a good idea for how many exemptions you should actually be claiming on your W-4. 

W-4 form and Worksheet: http://www.irs.gov/pub/irs-pdf/fw4.pdf

Withholding calculator Online: http://www.irs.gov/individuals/article/0,,id=96196,00.html

If you have need to revise and resubmit your form, your employer should always have a way to do this, so check with whoever handles the payroll and taxes at your job.

Good luck!