If given the following options, which would you choose? Would you rather...

• offer the federal government an interest-free loan for up to 16 months, or
• receive an interest-free loan from the government for up to 16 months.

Do you want a refund?

The heart of this choice is played out every year, when individuals choose their allowances on their W4 form which determines how much taxes to defer for federal taxes. Withhold more than you owe - you will get a tax refund. Withhold less than you owe - you will have to pay the amount owed. Every year when it comes time to file taxes, I like to ask people whether they owe taxes or are receiving a tax refund. It seems a majority receive a tax refund, and are very happy about it at that! I get it. I get the psychological win, but anyone can set up their withholdings in such a way to receive a tax refund, and in some cases a huge one. But is that the way to go? I do not believe so.

Come tax time, the amount of taxes you owe in total is set. Whether you had withheld $20k in taxes or $25k for federal taxes along the way does not matter because the amount you owe in total is only dependent on your income, deductions, credits, and exemptions. None of these are influenced by how much you withheld. If you have $22k in total federal tax liability, then the examples of withholding $20k or $25k in federal taxes lead you to owing $2k, or receiving a $3k refund when you file your taxes, respectively. However, the TOTAL amount you are paying for the entire year is the same.

Downside of over-withholding

When you over-withhold, you are giving the federal government an interest-free loan until the time you receive your refund. Using the numbers above, if you withheld an extra $3k in your paychecks, then you will receive $3k back when you file your taxes. Imagine if you held that money in even just a savings account at 1% interest rate. That is better than nothing. I also see people not maxing out their 401(k) and 403(b) matches because they "can't afford it." Yet, they still opt to receive tax refunds at the end of the year. A better plan would be to invest that money into their retirement account at an IMMEDIATE 50% or 100% match or whatever your plan states, and instead plan to not have a refund!

Other than my first half year of employment where my tax bracket was unusually low due to attempting to max out my 403(b), every year I have owed taxes when I filed. I plan it that way, and I make sure to save enough along the way to pay my tax liability. In fact, my goal is to pay the MINIMUM I can without incurring additional penalties. To avoid penalties, you will need to satisfy the Safe Harbor rules.

What do you think? Have I changed your feelings towards receiving a tax refund? Do you already employ the strategy I use? Please leave a comment below!