Many people like the feeling of receiving a refund each year when they do their tax returns—as it will soon be time to do for 2020 income.
But that refund basically means you paid in too much. You have been giving the government an interest-free loan, and all you are doing is getting back what you lent. That’s money that you could have put to use over the year, for example by investing it biweekly and getting the advantage of dollar cost averaging, rather than letting the IRS sit on it and pay it back to you at their convenience.
One reason is that many people forget about the IRS Form W-4 when after initially filing one, often at the start of a new job. The purpose for that form is to let the employer know how much to withhold from the employee’s paycheck. However, you might want to revise your W-4.
Suppose John starts a job when he is single. He only has one personal exemption on his tax return so he requests one “withholding allowance” on his W-4. With one allowance, a fairly large portion of his paycheck will be withheld for state and federal income tax.
A few years later, John is married with two children and a home mortgage. If he still claims one withholding allowance, he’ll be over-withheld and get a smaller paycheck, after tax.
On the other hand, John may be under-withheld if he claims four withholding allowances but keeps it at that level after his children are grown and his home mortgage is paid off. Then John might owe a sizable sum with his income tax return.
To avoid such problems, go over your W-4 whenever your financial or family situation changes substantially. Use the form’s worksheet and your prior tax returns to more closely match your paycheck withholding to your eventual tax obligation.