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Here's why that big tax refund isn't great news for you

A large tax refund may feel like free money, but it isn't.

As of March 17, the Internal Revenue Service has issued 62.5 million refunds, averaging out to $2,931. The federal agency expects to receive more than 153 million tax returns this season.

Many tax refund recipients are putting that money to work.

About a third of taxpayers getting a refund expect to save or invest the money, while nearly three in 10 will pay down debt, according to Bankrate.com.

Here's the bad news: If the IRS sends you a huge check this spring, it means you've likely overpaid on taxes throughout the year.

"A large refund from the IRS may seem like an advantage, but it isn't the best or most effective use of your cash flow," said Tim Steffen, director of financial planning at Robert W. Baird & Co.

"You're basically giving the IRS an interest-free loan," he said.

Know your withholding

If you're an employee, your employer gave you a Form W-4 when you were hired, which you can adjust to make sure the right amount of income tax is withheld from your paycheck.

On the form, you'll make note of your spouse, your dependents and your filing status; these are your "personal allowances." The more allowances you have, the less tax will be withheld.

"Some people read the form and think, 'I'm married and have three kids,'" said Cari Weston, director of tax practice and ethics at the American Institute of CPAs. "They end up with five allowances and owe substantial taxes at the end of the year."

The IRS has a calculator to help you figure out the correct withholding.

Overtaxed or undertaxed

The safest course to avoid owing a large amount at tax time is to fill out your W-4 as "single" or "married but withhold at higher single rate" and take no personal allowances.

However, this may also set you up for having excess taxes withheld throughout the year — leading to that large refund in the spring.

There's no denying the feel-good factor of getting cash back.

"Psychologically, it's not a terrible thing to have a little bit of a refund," said Jeffrey Levine, chief retirement strategist at Ed Slott and Co. in Rockville Centre, New York. "But if you overpay throughout the year, it's not the right move."

Tailor your tax load

Here's how to evaluate your withholding and make sure it's just right for you.

  • Review your W-4: Striking a balance for withholding will be based on your salary, your spouse's earnings, the tax bracket you're in and the deductions you take. If you decide to withhold less for taxes, be smart with your money.

    "Contribute to a dependent care plan at work," said Weston. "If you have a high-deductible medical plan, set aside some money into your health savings account."
  • Compare your tax returns: How did your tax load shape up last year, and how does it compare to this year? "Unless you've had a major change in your life, your deductions are similar year to year," said Levine.

    "If your effective tax rate was 20 percent on average last year, check your allowances to make sure you're close to 20 percent now," he said.

  • Talk to your accountant: The right amount of tax to withhold will vary from one family to the next.

    For example, if you are a high earner and have no mortgage and no kids, it might make sense to withhold more for taxes. Conversely, a working couple earning less than $100,000 with three kids and a mortgage may be able to withhold less, due to the credits and deductions they can take.
"If you've deliberately underpaid, the money should go someplace safe because this is a really short time horizon." -Jeffrey Levine, Ed Slott & Co.

Calculating your withholding is complicated if you have multiple sources of income: distributions from retirement accounts or cash from a rental property. You'll need to make estimated quarterly tax payments in those cases, Steffen said.

"Work with a CPA to do a projection and figure out what your tax liability will be at the end of the year," he said. "In a perfect scenario, you'll have a balance due when you file your return, but not one that's large enough to create a penalty."

  • Avoid tax arbitrage: If you withhold less in taxes because you have bigger plans with your paycheck, bear in mind that you'll owe Uncle Sam next year. Don't gamble your cash.

    "Some people do foolish things: 'If I invest the money and make 7 percent this year, and I beat the IRS' penalty, then I'm ahead,'" said Levine. "If you've deliberately underpaid, the money should go someplace safe because this is a really short time horizon," he said.

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