Tax refund: Withholding federal tax as a savings tool is bad strategy experts say

PITTSBURGH, Pa. -  Americans love getting a tax refund, so much so that many people intentionally have too much money withheld from their paychecks all year just so they end up with a fat refund in the spring.

In recent years, the average federal income tax refund for individuals has been around $3,000, according to the Internal Revenue Service. That means households on average gave the government an extra $250 to hold, interest free.

Some people say they use federal withholding as a forced savings plan, contending they aren't disciplined enough to save on their own.

So what's wrong with that?

The biggest problem is people are giving up control of their money, said Gail Cunningham, public relations manager at the National Foundation for Credit Counseling.

"It's a forced savings plan that does not allow any flexibility on the consumer's end," she said.

People often run behind in their bills or need emergency cash when an unexpected expense pops up, such as a big car repair or medical bill. A reserve fund could pay for the expenses.

"If you have an extra $250 a month, it could be the difference between financial stability and financial distress," Cunningham said. "Many people who receive an income tax refund don't realize that Uncle Sam is simply giving them back their own money, without benefit of interest," although with savings rates in the tank, the lost interest doesn't amount to much these days.

Still, instead of handing your money over to Uncle Sam, a better strategy is to use the cash to fund an emergency savings account, said William Strunkel, founder of Strunkel Tax & Accounting in Pittsburgh.

To make it easier to set the money aside, many employers with direct deposit allow employees to split their paychecks and have the money deposited into separate accounts, Strunkel said.

Having a second account reduces the temptation to spend the extra cash, say on eating out, he said.

Cunningham advocates a three-step program for breaking the tax refund habit.

Step one is to get a jumpstart on an emergency fund by plopping this year's refund into a savings account instead of spending it.

Next, raise W-4 federal withholding allowances so less money comes out of every paycheck.

"A lot of people think they can only adjust withholding once during the year," Cunningham said. "You can adjust any time you want."

Of course it's important not to over-adjust allowances and end up owing the government a bunch of money with no means to pay.

The IRS has a worksheet on its website for calculating the right level of withholding. Visit www.irs.gov and search for "withholding calculator."

The third step is to responsibly allocate the additional money each month from the larger paycheck.

"You don't want to get the money and blow it," Cunningham said.

The top priority should be keeping living expenses current, such as mortgage payments, rent, utilities and insurance premiums, she said.

If a savings account has to be tapped for an unexpected expense, replenish it with the following month's check.

The three-step system "stops the dependency on the income tax refund by establishing savings and providing money each month to keep a constant level of financial stability," she said.

 

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