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There's A Hidden Cost To Your Big Tax Refund

Getting a big fat check from Uncle Sam probably seems like a win. After working hard all year and diligently completing your tax return, a major windfall in the form of a refund feels like a reward. Unfortunately, it’s not.

The truth is that a tax refund is simply your own money, which you earned throughout the year, being paid back because you had too much tax taken out of your paychecks. Even though you worked all year to earn the money, you didn’t actually have access to it until the following April.

It might not seem like a big deal to get a tax refund. In a way, it’s like a forced savings account, which could be a good thing for people who aren’t great at consistently saving throughout the year. The problem? That “savings account” doesn’t earn any interest and you can’t withdraw from it if you need the money for something more important.

That’s a concept that personal finance site SmartAsset sought to explain with a new study highlighting tax refunds and their hidden costs. Getting a big refund in April isn’t so great after all.

How Tax Refunds Cost You Money Over Time

“Tax time is a time when people are generally very excited to get a refund, and sometimes, unhappy to be paying taxes,” said AJ Smith, vice president of financial education at SmartAsset. “If you’re getting a refund in 2020, it means that throughout 2019, too much money was taken out of your paycheck by the government and now you’re getting that money back. You essentially gave the government an interest-free loan.” 

Smith said her team wanted to show what that really could mean if you took intentional action with that money throughout the year instead of getting a refund later.

As you can see below, waiting to receive your refund in April might mean missing out on savings or investment interest, or paying more interest on debt, depending on how you’d choose to use the funds if you received them in your paycheck instead.

Analysis by SmartAsset shows how much money you may lose out on throughout the year by waiting to receive a tax refund. The difference is even more dramatic if you consider compound interest.  (Photo: SmartAsset.com)

To calculate the cost of getting a tax refund, SmartAsset assumed that the refund would otherwise be spread out evenly across the year (i.e., one-twelfth of the tax refund was received at the end of January, one-twelfth was received at the end of February and so on). Additionally, they assumed that the taxpayer received the refund on April 15, though some people may actually get their refunds earlier or later.

Losing out on $12 in savings account interest, as one example shows, probably won’t wreck your finances. But consider how impactful losing out on a year of investment returns can be ― especially because that money will continue to compound over the years.

For instance, according to SmartAsset’s analysis, receiving a $5,000 tax refund instead of getting that money in your paycheck and investing it in the market could cause you to lose out on $502 in returns. That’s nothing to sneeze at. But let’s say you’ve been happily getting your $5,000 refund for 20 years. If you had been investing it throughout the year each year instead, plus reinvesting the returns, you’ve missed out on making $204,585 ― about double the total amount you’ve been taking home in a cash tax return. 

What $5,000 invested every year for 20 years looks like. (Photo: Investor.gov)

“You do benefit when you do that from compound interest. That’s the money that your money makes then making more money,” Smith said. “And so you’re losing out on that opportunity, even if you are really great and take that whole refund and put it towards your goal of ... saving or investing.”

What if you chose to pay off debt instead? According to the study, using that same $5,000 to pay down credit card debt throughout the year instead could save you $595 in interest. “It means that was interest you were paying throughout the year, on something that you eventually paid off, that you could have paid off throughout the year and saved yourself that money,” Smith said.

How To Adjust Your Tax Withholding

So how do you ensure that rather than receiving a refund (or owing money) at tax time, you break even?

Whenever you start a job, you fill out a W-4 form to determine how much tax should be withheld from your paycheck by your employer. You can update this form at any time for the upcoming tax year, if desired. In fact, you should update your W-4 if you experience any major life changes such as getting married or having a child.

Just be aware that, along with the many other recent updates to our tax code, the way W-4s work also changed. It no longer has you claim “allowances,” which were tied to personal exemptions ― money that could be deducted from your taxable income for you and any dependents. Exemptions were eliminated as part of the 2017 Tax Cuts And Jobs Act, so the W-4 was updated to reflect this big change.

Now, the new W-4 for 2020 is completed by answering a few personal questions about you and your spouse’s job, dependents and other adjustments. Your employer will update your W-4 for this year based on last year’s information, but it’s not a bad idea to double-check that the info is correct. If your W-4 is completed accurately for 2020, you should end up having roughly the correct amount of taxes withheld from each paycheck. 

Note that certain people, especially lower-income taxpayers, will still end up getting a refund thanks to tax credits. But that’s extra money awarded to them by the government and not earnings withheld from their paychecks.

The Bottom Line

“Personal finance is personal,” Smith said. “And if you’re someone who is really great at getting that $3,000 and doing something really smart and intentional with it ― you’re able to put that money to good use ― that’s great.” However, she said the point is that many people might think of their refund as found money they can use to treat themselves, when it’s really just part of their wages.

“It’s really important to make sure that you’re the active party when it comes to your money and that you’re intentional about what you’re doing, and that it matches up with your values and your goals. That can be a really powerful thing,” Smith said.

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Flip items for cash

Dustyn Ferguson of the personal finance blog Dime Will Tell said that flipping secondhand items on websites such as eBay or Craigslist is an underrated side hustle. “The things from our childhoods are often worth a lot of money these days and can be picked up for pennies on the dollar to then be resold for a good profit.” The best part? You don’t need any special skills or much money to get started. “Just head out to a yard sale or thrift store and bring along the eBay app to see what is worth money. Once you find something that’s well below what it’s worth, buy it and list it,” Ferguson said.

Turn your passion into a business

If you have a hobby, there are plenty of people out there willing to pay you for your skills. Whether you’re a photographer, guitar player or know how to fix computers, “turning your hobby into a money-making machine is an easy, low-barrier entryway to make some side money,” said Ferguson. He suggested starting by checking out the gigs section of Craigslist for ideas.

Become a mystery shopper

Jen, the blogger behind Smarty Pants Finance, is a big fan of mystery shopping as a way to earn income and cut expenses at the same time. “For example, last month I got my oil changed. I made a little money, and the cost of the oil change ($70) was reimbursed,” she said. Jen added that she also eats at restaurants as a mystery shopper four to five times a week, which allows her grocery budget to be less than $100 a month. “Next month I am taking my first trip to Asia, and it will be at no expense to me!” she said. She gives details about mystery shopping on her blog.

Rent out your home

Whether you use a service, such as Airbnb or VRBO, or go about it independently, your home can be a lucrative path to earning more income. In fact, you can rent out a single room or your whole place. Veronica Hanson, who teaches homeowners how to leverage their homes for income, began using Airbnb in 2017. “I rent my house out for about $500-$1,100 per night and sleep at my parents’ house,” she said. “Sometimes I get a hotel (for $125-ish) or tag along on my husband’s work trips. There was even a week I was on a free trip to Cabo from another side hustle.” In her first year, she generated $41,331 in revenue.

Take care of other people’s fur babies

If you’re an animal lover, pet sitting can help you pull in extra income and barely feels like work. “If you already have pets, you’re already doing the work,” said Jon Nastor, creator and host of the Hack the Entrepreneur podcast. “Adding another one to the mix is almost like passive income.”

Become a virtual assistant

Working remotely is a trend that’s only getting more popular. In fact, 3.9 million employees do it. According to Ashley Patrick of the blog Budgets Made Easy, “You can find local businesses that may need data entry, remote customer service or social media management.” Often, these jobs are part time. Even better, you don’t have to put on pants to do it. Patrick suggested searching sites such as Upwork and Freelancer for virtual assistant jobs.

Teach English

Teaching English abroad is a great way to make money while traveling the world. But if you don’t want to spend a year or longer in Asia or the Middle East, you can also teach English from the comfort of your own home. You can find work online through VIPKID and other companies that pay you to teach English online,” said Patrick, who did it for about six months. “It is easy, and you get to make your own schedule. The hours are late at night and early in the morning,” Patrick noted.

Launch a drop-shipping business

Todd Kunsman, who runs the blog Invested Wallet, suggested giving drop-shipping a try. This essentially means becoming the liaison for companies with products that you buy at a fixed cost, then sell through your own store at a 15 percent to 25 percent markup, according to Kunsman. “This requires a bit more work setting up a tax ID number and LLC, and making friends with companies. But there are tons of options. I have two friends who started one 10 years ago and now do over $1 million per year in sales.”

Start a blog

As you probably noticed, side hustling and blogging often go hand-in-hand. It’s a crowded space, but if you’re able to garner a niche audience through your writing, it can be a significant source of income. “I started a music blog back in 2010 and was able to do some brand partnerships and other advertising that would make me a few hundred bucks every now and then,” Kunsman said. “Now I run Invested Wallet, which is starting to do the same for me and also has the potential to make great passive income or become a full-time gig in the future.”

This article originally appeared on HuffPost.