How to Manage an Income Tax Refund
When we look at the spending habits of Americans, do we really think that there is no correlation between the rise of used car sales and the mailing of Income Tax Refunds in the month of February? Certainly not!
When the federal and state income tax refunds are mailed out each year, beginning in February, the national economy gets a little help. Why? Because we rush right out to spend our refunds. But how should we really be handling this extra bit of income?
In reality, income tax refunds are NOT extra income. You have already earned that money, sent it to the federal and/or state government in the form of tax payments, and income tax refunds are simply the government giving you back money if you paid too much. It’s almost as if you loaned the government that extra money, and now you are getting it back.
Income tax is removed from your paycheck based on what the government estimates you will owe at the end of the year. This estimate is based on what your income will be, minus any deductions that you might have. You fill out paperwork at the beginning of any job, and part of that paperwork helps your employer know what to withhold for taxes and send to the appropriate place. Deductions are for items like head of household, dependents, and a few other qualifying things. The more deductions you have, the less tax is withheld from your check.
The paperwork is designed to be as accurate as possible, so always be sure to fill it out completely and correctly. If you put down too many deductions, you will then owe income tax at the end of the year. On the other side, if you put down too few deductions, you will end up with a larger refund at the end of the year. Some people intentionally put down too few deductions, using their refund as a sort of savings account – they then plan for large expenditures when they get in their tax refunds.
The realistic approach is to treat a tax refund just like any other income you receive during the year. Set aside your normal amounts for savings, spending, retirement, etc. You earned this income months before, so be sure to treat it like income, and not just a bonus check that you can run out and blow.
The temptation to run out and spend our income tax return is natural. We all like to get a little extra money, and then do something a little extra special with that money. Other people are tempted to do the exact opposite, and to save every extra cent they can. A balanced way to approach dealing with tax refunds is to play a little psychological trick on yourself – plan to spend half, and to save the other half. This helps us not go overboard in either direction, but also satisfies the impulses we have to do both. Even though we know we are tricking ourselves a bit, it still seems to work every time.
Whatever approach you take to tax withholding and year-end tax refunds, do it intentionally. Plan how you would like to handle the “tax/refund issue,” and then follow through with your plan. This really is the way to take control of your money, and not get caught in the grip of an unhealthy tax refund mania.