Posted by Lending Club :: May 3, 2008 @ 9:36 am

When you get your first income tax refund, it probably seems like a real bonus. As time goes by and you receive refunds year after year, not only does the novelty of a refund wear off, but you also come to count on that money.

There’s nothing wrong with using your income tax refund responsibly. Paying bills, reducing debt, or building an emergency fund are all noble uses. In fact it’s much better than the alternative, alluded to in the introduction to this post. Blowing the money on something luxurious may make you feel good temporarily, but won’t have the lasting effect of responsible use. But even good use of your refund is not optimal.

The reason is that repeatedly getting a large income tax return means that you have been having too much taken out of your paycheck. Having too little withdrawn and owing money at the end of the year probably sounds much worse, but that may be more desirable than getting a big refund.

By reducing the amount withheld from your paycheck, you will take home a little bit more each pay period. If this extra money can be used to pay down debt (or avoid borrowing money) throughout the course of the year, rather than as a lump sum at the end of the year, you could end up saving money.

Let’s assume that you have $5,000 of credit card debt at 15% interest and you are making the minimum payment of 2% of the balance or $10, whichever is greater. If you got a tax refund of $2,600, you would be correct to assume that using it to pay down your debt could help your financial situation. But consider how much more it could have helped if you had gotten that refund over the course of the year. If you reduced your withholding so that your take home pay was $50 more each week (an extra $2,600 a year), your refund would have been zero. Paying an extra $216.67 each month (which is the same as $50 a week) would bring your debt at the end of the year down to $1,767.86 from $1,954.32, a savings of $186.46. In this example, you paid down your debt by $2,600 in both cases. By taking the money over the course of the year, rather than as a refund at the end of the year, you were able to get a head start and ended up saving an extra $186.46 without paying any extra.

While reducing your withdrawals can be beneficial, as seen in this example, be careful not to overdo it. Owing too much at the end of the year could lead to penalties. Ideally, your withdrawals would just cover your taxes owed, leaving you with a return of zero. Doing so effectively gives you your refund throughout the year, when it can be put to even better use. Now that the tax season has passed, it’s a good time to look at your situation and make any needed adjustments.