With 2019 coming to an end, it will soon be time to file your income taxes for the year.
While it’s undoubtedly nice to get a big chunk of change back from the IRS, it’s actually bad news if you get a big refund.
If you do, it means you overpaid the IRS and gave them interest-free use of your money.
There’s an opportunity cost to this, and it’s one you should try to avoid by changing your withholding for next year so you don’t make this mistake again.
How many Americans are getting refunds?
According to recent data from the IRS, around 73.2% of people received refunds after filing taxes in 2019. This is about 96 million people across the country. It’s also a slight increase from the prior tax filing year, when just 73.1% of tax filers received a refund.
For the average American, these refunds are not small ones. The average refund owed to Americans who filed their taxes in 2019 was $2,725. This is a slight decrease from the average refund of $2,780 that resulted from 2018 tax filings — but it’s still a huge amount of money.
Why is it a big mistake to get a tax refund?
If you’re among the majority of Americans who will be getting a large check from the IRS, it’s tempting to feel good about your financial “windfall.”
But the money you’re getting back isn’t a windfall at all — it’s your own money that you didn’t have use of for months because you paid too much to the IRS. Overpaying your taxes has a real cost that you have to consider. Some of the big downsides to getting a big refund include the following.
Increased interest costs
If you owe money to creditors, the extra money you’re sending the IRS could be better spent paying down your debt.
If you get the average $2,725 refund, you overpaid the IRS by close to $230 per month. If you have $6,000 in credit card debt at 17% interest and are currently paying $150 per month, you could’ve added that $230 to your current payment. Doing so would’ve brought your balance down to $2,171 after 12 monthly payments.
If you’d just continued paying the minimum, your balance would be $5,156. Even if you applied your refund to pay down the balance, you’d still owe $2,431 — $260 more than if you’d been making extra payments the whole time.
Even if you don’t owe money to creditors, overpaying the IRS by $230 a month decreases the funds available to you, thus increasing the chances you’ll have to borrow money for everyday expenses or emergencies. This could mean paying interest on debt you incur because your cash is tied up and inaccessible.
Lost opportunity to use the funds
Paying the IRS extra also means you can’t do other things with your money.
You can’t use it to save up for an emergency fund or to pay for a vacation. You also can’t invest the funds — which means you miss out on investment gains. If you had invested that $230 per month and earned an 8% return on your investment, you’d have $2,863 at the end of the year. This is $138 more than you’d get in a refund check sometime after the beginning of next year.
Why waste $138?
Lost buying power
Thanks to inflation, your money loses a little bit of its value every day. So if you lend the IRS $230 in January, even if you get it back in April of the following year, the money you get back won’t be worth quite as much as it was before. Assuming a 2% inflation rate, you’d lose close to $9 of the value of your hard-earned dollars.
Don’t make this common tax mistake
If you’re on track to receive a refund for the 2019 tax year when you file your returns in 2020, there’s not much you can do now — you’ve already overpaid the IRS.
But you can talk to HR and let your employer know you want less money withheld from your check next year. Instead of giving your dollars to the IRS early, keep the money in your bank account and use it for something that helps you out over the course of the year.
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Source: The Motley Fool