Have you created a “bare-bones” budget only to realize there still isn’t enough money left over to save for an emergency fund or pay off debt?
Would you be interested if I told you that there’s a small tax tip that might increase your monthly cash flow?
I thought you would. 
BIG Tax Refunds
Have you ever asked someone about the amount of their tax refund and had to fight back a smile because yours was bigger? Be honest. I’ve even done it!
This big fascination with excessive income tax refunds always comes during the first few months of the year. It’s almost like there’s a competition to see who’s going to get the most money back.
The issue surrounding a large tax refund is that usually, it’s just a return of your excess withholding. In other words, you sent the US Treasury a larger percentage of your paycheck than necessary and they’re just sending the excess back to you.
But what’s the problem with getting a large refund? It’s like forced savings, right?
Mental Accounting
The main argument about large tax refunds always runs, “You’re just giving the government an interest-free loan.”
While true, that’s not what I want to focus on. For this article, I want to talk about mental accounting.
Put simply, mental accounting is about how you view incoming and outgoing money in your head.
For example, you’d probably view an extra $100 a month added to you paycheck as “more money for bills.” But what if you get a $100 bill from Grandma on your birthday? While it’s the same amount of money, I can almost guarantee you’ll spend it differently. Why? Because you’ll place the money in a different compartment in your mind. It’s easier to splurge the birthday money because it feels like unexpected income.
A large tax refund can be a windfall that most people see only once a year. The 2012 tax season produced an average tax refund that was roughly $3,000. That’s a good chunk of change!
What would you do with a windfall of $3,000?
You might say the usual stuff like, “I’ll use it to pay off debt” or “I’ll save it for a rainy day.” But what you say and what you actually do are two completely different things.
You see, just like birthday money, a large tax refund may get compartmentalized a little differently in your mind.
While you may think that you’re going to do responsible things with the money, it could hit your bank account at precisely the wrong time.
Maybe your friends ask you to go on a cruise with them. Maybe you just had a discussion with your spouse about how you wish you could afford new appliances.
Before you blink, your tax refund is gone. You spent it on something that wasn’t budgeted for.
In summary, even though a tax refund is technically a part of your salary, it doesn’t feel like it.
It feels like someone just gave you a sizable amount of money, which can lead to less desirable financial decisions.
Adjust Your Tax Withholding
If you receive a large refund each year but have a rough time finding money to save or pay off debt, you should consider altering your withholding.
For example, if you take the average 2012 refund of $3,000 and divide it by 12 months, you get $250.
How would an extra $250 per month affect your budget? I’m guessing it would help out nicely.
Adjusting your federal tax withholding isn’t extremely difficult, but it does require some monitoring.
First, you should use the Internal Revenue Service’s Tax Withholding Calculator.
In the tool, you’ll input information about your anticipated income, deductions and credits for the current tax year. You’ll also enter information from your most recent paycheck detailing the amount of federal income tax you’ve had withheld to date.
When complete, the calculator will give you a detailed summary of what your anticipated tax is for the current year and what you’ll have withheld if you do not change your W-4 exemptions.
If you want your tax withholding to be spot on (which would mean bye-bye big refunds), the calculator will show you how to change your exemptions to make that happen.
To change your exemptions, you would just need to complete a new W-4 with the recommendations and hand it to your employer’s payroll department.
To help clarify the process, here’s a video I created showing the calculator in use:
**IMPORTANT** – The calculator only uses information from one data point. Therefore, if you have a change in your tax situation (a new job, pay increase, bonus, loss of deductions, new child, etc.), you’ll need to use the calculator again using the new information. Also, if you’re subject to the alternative minimum tax, self-employment tax or other taxes, you’d probably be better off using Publication 505.
You’ll also want to adjust your tax withholding in the beginning of each calendar year. This will ensure that you’re still having the correct amount withheld.
Also keep in mind that this is only for your federal taxes. Check with your individual state to see if they have a calculator similar to that of the IRS.
How to Handle Your New Cash Flow
Now, this tactic works only as well as the individual using it.
If you’re going to just blow this new cash flow on stupid stuff, then forget it. It’s not worth the hassle.
Handled properly, this “new” infusion of monthly cash can be a big psychological boost.
Before, you might have fizzled out due to the little flexibility you had with your budget. It may have looked like it was going to take eight months to save $1,000.
Now, you’ll hopefully be able to see the light at the end of the tunnel. Your goals will be attained much faster without having to wait until tax season.
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Do you receive a big tax refund? How much could you add to your monthly cash flow if you made a change?
Note: None of this information should be construed as tax advice. Please seek the help of a tax professional if you have questions or concerns about your personal situation. You can find one in your area by searching the National Association of Enrolled Agents website.
The post Use IRS Tax Withholding Calculator to Increase Your Net Pay appeared first on Adam Hagerman, CFP®.