A tax refund is not a gift from Uncle Sam

Let’s talk about those tax refunds that Uncle Sam is sending out to households all across the country. Do you talk to your kids about taxes and refunds? Probably not.

Here’s some information that will help you better understand what’s really going on with refunds so you can give your kids an idea of what’s ahead when they start getting their own paychecks.

This year, about two-thirds of households expect to get a tax refund with the average being around $3000. Taxpayers get refunds because they overpaid their taxes. Imagine overpaying your mortgage every month; you’d certainly ask your bank for a refund. And you’d figure out a way to stop overpaying.

You would not think of the refund as a gift because you know it was your money all along. With taxes, a refund simply means that because you had overpaid your tax bill the government has to give the extra money back.

You are getting your money back. Your money came from your paycheck. It’s money you earned and gave to Uncle Sam. Every dollar of every refund is money that taxpayers hand over to Uncle Sam at 0 percent interest.

The average $3000 refund got its seed money back in January 2011 through the withholding from your first paycheck of the year. Each paycheck thereafter added another chunk to the refund.

After twelve months of your money sitting in Uncle Sam’s bank you can kindly ask to get your money back. You earned 0% interest on your money that was just lying around in Uncle Sam’s bank for year.

The money doesn’t automatically fly into your bank account. You have to wait for your W-2 and other tax information documents. Then you have to endure that annual headache called the Federal Tax Return.

Then one glorious day your money comes back to you in the form of a tax refund.

According to the NRF 2012 Tax Returns Consumer Survey about 40% say they’ll use it to pay down debt, while about 44% say they’ll put it into savings.

In both cases taxpayers are losing money simply because they gave up control of that money for an entire year. Let’s look at the two options to see what it means for your bottom line.

Option 1: Using a tax refund to pay credit card debt

Let’s say you carry a $3000 credit card balance with interest around 15%. That interest will cost you $450 over one year. Using $3000 will reduce your credit card balance but you really need to pay $3450 to zero out the balance plus the interest. In effect, you paid Uncle Sam $450 to hold your money during the year.

Option 2: Using a tax refund for savings

Now, suppose you decide to put your money into savings. At the current passbook interest rate of around 1% your money would earn less than $20 during the year.

The good news is that your money would earn $20 more than if you let Uncle Sam hold it for you at 0% interest. However, that $20 doesn’t make much of a dent in potential credit card interest that could be costing you hundreds of dollars a year.

There is another possibility.

Option 3: Reduce your refund and keep your money

How can you keep your money out of Uncle Sam’s hands? Simple. You can increase your take-home pay by adjusting your W-2 so less money is withheld each month for taxes.

This simple change can put an additional $200 to $250 per month in your pocket. Ideally, you want the smallest refund possible so you can have more of your money during the year.

With that extra money you can pay more on your credit card balance, with the goal of paying in full each month. Or you can start investing it in your retirement fund or other long-term savings program. In either case your hard-earned money will be working for you each month instead of taking a vacation at Uncle Sam’s bank.

For information on how to change your withholding, talk to your payroll office, tax preparer, or follow the instructions on the IRS website. On a personal note: We have re-adjusted our withholding many times over the years so we keep the refund, if any, quite small.

The sooner you make a change the sooner you can start keeping more of your money. Just think of it. By the time you get the refund on your 2011 taxes you’ve already handed over several hundred dollars in 2012. Once again Uncle Sam will hold your money, interest free, until you ask him to give it back when you fill out the paperwork next year.

By recognizing the cost of overpaying your taxes, you can explain to your kids the importance of paying attention to your withholding amounts. Money management is making the most of the money you have. Taxes are just another part of everyone’s financial situation

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