If you are like most people, getting a sizeable tax refund is a celebration. That unexpected windfall might lead you to dreams of vacations or purchases of those seemingly unattainable special items that suddenly became attainable. But before the endorphins lead you to bad decisions, take stock of reasons for the large refund and how it fits into your overall plan.
Reason: Over-withholding taxes
A large refund could be a simple indication: The government over-withheld taxes. In this case, you have graciously (and likely unintentionally) provided the government with an interest-free loan. While you may delight in the refund, at the end of the day, this is not a sensible way to handle your hard-earned money. If you’re over-withholding, see your Human Resources department to revise your exemptions to a greater number to reflect, ideally, a break-even withholding.
Reason: A unique or non-reoccurring transaction
If your refund is due to a unique or non-reoccurring transaction, like a large donation or a substantial business loss, don’t change your withholding or estimated tax payments.
If you’re not sure WHY your refund is so large, compare your prior year’s return with the current year and determine what is different. It is not beyond the realm of possibility that your return was incorrectly prepared, as in a human or computer-generated glitch. In this case, don’t spend your newly found bounty too quickly.
Your personal exemptions are recorded on your W-4 form and used to program the payroll to the correct amount of withholding for that level of exemptions. If you are able to Itemize Deductions on Schedule A in excess of your Standard Deduction, and you do not have sizeable amount of other income that is not subject to tax withholding, you might be better off claiming more dependents than just one for each person you claim on your return.
If your marital status has changed during the year, you need to adjust your exemptions to reflect that change.
Generally, your status as of December 31 is the status for the year. So even if you get married on December 30, you get to claim Married vs. Single filing status. The same is true if you go from Married to Single. If your situation changes, you need to adjust your W-4 to conform with that change.
Good financial planning is about action. Getting a good grasp on the small stuff (that the books tell you not to sweat) can enhance your financial success and your overall satisfaction. In a world where we control very little, each action we take to better our situation is not only enriching, it is empowering.
If, after appropriate investigation, you find that you need to adjust your exemptions to avoid the interest-free loan to Uncle Sam and put more dollars into your paycheck, here are a few tips to best handle your increased net pay.
Calculate the net increase to your pay.
- Look at your current level of contributions into your 401(k) or 403(b) or other contributory plan and increase it by at least 20% of the net increase. If you’ve maximized your allowable contribution, you’ll want to create another outlet for your excess cash.
- Take the balance available after the increased retirement plan contribution and look at your current accumulation pots. Short term emergency fund, mid-range goals and long-term accumulation. If you’re emergency fund is lower than, generally speaking, 6 months of living expenses, channel the funds there.
- Nothing beats having those unanticipated expenses covered and available. If you’re ok on that end, start funding up to other goals.
Use your tax refund in a way that adds to your overall happiness, satisfaction, comfort and security. Ask yourself, before you buy that gaming chair or book that vacation, whether you are moving closer to your life’s goals—or further away. Remember, your actions and decisions decide in which direction you move. If the right answer for you is the dream vacation, then celebrate and have a blast, but let’s try and keep more of our resources aimed appropriately to our highest and best needs. Happy Tax Time!