Mellody Hobson: What to Do With Your Big Refund

March 22, 2006 — -- According to a recent USA Today analysis of Internal Revenue Service records, taxpayers overpaid their federal income taxes by 29 percent in both 2003 and 2004. Basically, many taxpayers are having nearly twice the amount of the traditional safety margin withheld from their paychecks to avoid having to pay a tax bill, but it could be costing them money.

This additional withholding translates into $10 billion annually, or roughly $100 per tax return. The overpayment trend seems to have continued in 2005, as tax refunds are currently up approximately 4 percent from 2004 -- the average 2005 tax refund is about $2,400 to date.

Why are refunds bigger this year?
It is important to keep in mind that average tax refund amounts tend to be higher earlier in the tax season because the taxpayers who expect a refund file early to get their money faster. That said, there were some new tax changes in 2005 that may contribute to the larger refunds.

For example, the child tax credit, which was supposed to revert to $700 in 2005 (from $1,000 in 2004), was extended through 2010. The amount will remain at $1,000 for each qualifying child, assuming you are within the required income thresholds.

Individuals living in states without income taxes also benefited in 2005: Taxpayers who itemize deductions will have a choice of claiming a state and local tax deduction for either sales or income taxes on their 2005 returns. Additionally, parents and students may be eligible for higher deductions and credits for 2005 tuition and fees.

Isn't getting a bigger refund a good thing?
No, a bigger refund is not necessarily better. Getting a refund means you overpaid throughout the course of the tax year, which essentially translates into loaning money to the government interest-free.

Over-withholding is growing the fastest among families earning $50,000 or less each year, because they tend to benefit the most from tax credits. Oftentimes, these are the families that need the money the most and end up paying $100 or more to obtain a refund-anticipation loan to get this overpayment back sooner. So, while some may believe this "forced" savings is a good thing, it may actually cost you more money than you think.