The average tax refund each year is always in the thousands of dollars. In 2009, the average tax refund was over three thousand dollars. That's $250 a month! Can you imagine what you would do if you had an extra $250 each month? Stop imagining because that's your money. You were just letting the Treasury Department hold onto it for a year.
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Why should you adjust your withholding?
The core reason you should adjust your withholding is because you shouldn't be giving the government an interest-free loan. If you had that money through the year, you could use it to pay down any outstanding debts you may have. If you are carrying a credit card balance, you could use that money to pay down the balance and pay less interest. If you are carrying a mortgage, you could use the extra cash to pay that down.
If you are debt-free, you could be saving that money into an emergency fund or towards your next vacation! It doesn't really matter what you'd use the money for because it's yours and there's no reason why you shouldn't be getting it. If you were to save $250 a month for a year, earning just 1 percent interest (high-yield savings accounts aren't paying what they used to!), you'd have an extra $13 at the end of the year. While $13 doesn't seem like much, it's better than zero.
How does this happen? Our tax system is so complicated, there's no way that you could fill out a W-4 and expect it to be 100 percent accurate. The W-4's Personal Allowances Worksheet only has eight steps, our tax code is thousands of pages with all sorts of exceptions, exemptions, deductions, rules and regulations. We have huge refunds because an eight question form can't possibly capture all those pieces.
How do you adjust your withholding? First, you'll have to fill out another Form W-4 to give to your employer after consulting with the IRS Withholding calculator. The IRS calculator is the best way to calculate how to adjust your withholding because it integrates the myriad of recent stimulus bills into an easy to use calculator (and it asks you more than eight questions!).
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Why would you not want to adjust your withholding? For some people, the tax refund is a way of forcing themselves to save. Sacrificing $13 of interest is worth it if it prevents you from spending the money on things you don't want. When you adjust your withholding, you'll start to see your paycheck get a little bit larger. It won't increase to the point that you'll really notice it and, if you don't budget, it's easy to miss and never "realize" those savings. Another risk is that you'll withhold too little and have to pay taxes at the end of the year.
As long as you don't underpay by too much (safe harbor rules) you will not have to pay a penalty. That's why I always recommend the IRS calculator when people ask for resources on helping them calculate their withholding. So fire up the calculator, fill out a new W-4, and only pay the government what you actually owe.