We know there’s a lot of talk about tax refunds and why the IRS is taking forever to process them.
We actually have some really good posts on this blog explaining what might be the causes of that so be sure to check those out after reading this post.
But in today’s post, we’ll actually be explaining why having a huge tax refund or any refund at all is not necessarily a good thing and the reasons might surprise you.
What is a Tax Refund?
Well, it’s not just free money from the government (though it might feel that way).
Usually, people are excited to receive a tax refund and it is really good news for them.
But as a CPA who prepared at least hundreds of returns, we can tell you that a tax refund is usually the result of a mistake.
A tax refund is a refund of the taxes you OVER paid.
So in actuality, you paid more in income taxes than was necessary by law. You gave the IRS an interest-free loan.
It’s sort of like this. if you go to the store and buy a computer for, let’s say, $1100, that’s a pretty expensive computer, right?
But you paid for it.
Fast forward, a year later and the store during its annual audit or something realizes you mistakenly paid more for the computer than necessary and they decided to give you $500 back.
We mean, it’s great that the mistake was caught but is it so great that they had your money hostage for over a year?
Well, not so much.
What Tax Refunds Are Not Good?
Tax refunds are not good because instead of that money being held by the IRS and taking 1700 years to process…
…YOU could have possession of that money and use it for the things you want.
For example, like investing that cash.
Let’s say you filed your 2020 tax return and are getting a $3,500 refund. Yay!
But not really. If you had that $3500 last year and invested it in the stock market, that $3500 would be worth $5472 as of 3/31 for the last 12 month period.
Your $3500 just turned into almost $5500 really quick.
Obviously, the stock market fluctuates and changes day to day. But we do know it generally grows over time.
Or let’s use another example. Maybe you bought a car last year and put down $3500 less than you normally would because that money was with the IRS and not with you.
Based on the average financing rate of a vehicle, which is 5%, you just paid $175 more in interest on your car payments.
And why is that? The IRS had YOUR money – mistakenly!
Other Reasons for Tax Refunds
Now it’s important to note that people get tax refunds for a number of different reasons which are UNRELATED to overpaying in taxes.
Those reasons include:
1. The Child Tax Credit or CTC
If you have kids, the CTC pays you a refundable credit of $1400 per child.
2. Earned Income Tax Credit
Taxpayers who earn low to moderate income during the year qualify for the earned income tax credit or EIC.
This tax credit is also refundable meaning it reduces the taxes you owe and could result in a refund.
3. American Opportunity Tax Credit or AOTC
This is for eligible students to help offset the expenses associated with higher education and has a max refundable amount of $1000.
What these credits have in common is that they can be refunded to you and are NOT based on the taxes you paid.
They are more so tax benefits for those who meet certain criteria like having kids or going to college.
These are NOT mistakes and are actually tax benefits available to millions of people.
How to Avoid Tax Refund Mistakes
To avoid the mistakes associated with a large refund that is paying too much in income tax, you need to consider filling out a new W-4 with your employer.
Form W-4 is used by your employer to calculate the amount of taxes that need to be withheld from your paycheck.
You receive a tax refund when too much money is withheld.
To have less money withheld, you need to decrease the withholdings on your W-4 and submit the update form to your employer.
This way, more money will be paid to you with each paycheck and less will go to the IRS.
Disclaimer: If you decrease your withholding TOO much, you may owe taxes at the end of the year when you file your tax return.
It would be good to consult your tax advisor on this.
Business Owner Tax Mistakes of Overpaying
If you’re a business owner, you’re typically due a refund when you overpaid your estimated taxes.
Income for a business can change year over year. This can make it more difficult to estimate what you should be paying in taxes.
There’s an IRS Form 1040-ES, estimated tax for individuals that when completed correctly can accurately assess the amount of taxes a business owner should pay,
If you believe you have overpaid in taxes, you can request a refund by filing your annual tax return of Form 1040.
Your tax return will report your income, deductions, and other tax information.
Through its various questions and schedules, it helps calculate the correct amount of taxes that should have paid and any refund amount.
Once the IRS accepts and processes your information, a direct deposit or check will be sent to you. Processing times are normally not longer than 21 days.
However, as we’re sure a lot of you know, delays can happen and are currently happening.
So it’s best to not count on your refund when making important financial decisions.
Though if you already had the money, you certainly could do whatever you’d like to with it.
But when it’s in the government’s hands, there’s no telling when you’ll actually have that money back.
This is ultimately the reason why BIG tax refunds are not GOOD.
It’s best not to trust the government with money entitled to you. Pay only what NEED to and stop waiting on money that’s already yours!
Once you finally receive your tax refund, use those funds wisely. Treating yourself is not always a bad idea.
But if you have other important financial obligations like paying off debt or funding an emergency, it is certainly wise to put some of those funds there.
We’d be happy to help you!