Purpose of this article: to explain why tax refunds can be seen as good and bad.
Overview:
I’d like to take a moment to explain something my clients often ask me: Is getting a tax refund each year a good or bad thing?
Each year when you file your tax return with the IRS, one of two things will happen:
1. You will owe money and have to pay the IRS or
2. The IRS will owe you money and you will get a refund.
When you get a refund from the IRS this means that each paycheck you received during the year had too much tax withheld and taken upfront. In essence, you have overpaid your taxes during the year.
When you have to pay the IRS this means that each paycheck you received during the year had too little tax withheld and not enough was taken upfront. In essence, you have underpaid your taxes during the year.
The rate/amount that the IRS takes away from each paycheck is determined by Form W-4 [Direct Link to Form: Here], which you typically complete and file with the payroll department of your employer on day 1 of your job, and never revisit.
On an aside … I will complete another detailed write up on how to properly fill out Tax Form W-4, but the point I want to make here is this form determines a big portion of whether or not you will get a refund or pay come April.
Team Bad: Getting a refund is bad because…
• When the IRS writes your refund check, they are just giving you back your own money they owe you, without any interest.
• You have overpaid on taxes throughout the year. It’s your cash that the federal government took from you and is now returning to after months of holding on to it. Oh and they aren’t giving you interest!
• It isn’t the most effective use of your cash flow because you are giving the IRS an interest free loan.
• When we get large sums of money, we tend to splurge because of the Windfall Syndrome. This is because emotionally, our tax refund feels like a windfall, even though this is simply the government returning our money back to us, with no interest.
Team Good: Getting a refund is good because…
• Psychologically speaking, there is no better feeling than getting cash back. Especially large sums of cash.
• If you are disciplined, this huge tax refund can effectively force you to save if you can earmark the refund and send it to a savings account. Same argument can be applied to using the refund to pay down debt.
Blue Elephant’s Verdict:
Getting a refund is economically bad but psychologically good.
In 2015, the average tax refund was roughly $2,860 and approximately 70% of all tax returns resulted in refund checks being issued. The 2016 numbers are not yet published but there is a high degree of likelihood that they will match the 2015 numbers.
Put another way, 7 out of 10 US households that were issued refunds,gave the government $238 each month interest free. This is money that could have been spent building an emergency savings fund. And even if it earned 1% in an Ally Online Savings Account, that would be better than nothing. On top of this, this is money that could have been spent paying down high interest credit card debt.
No matter how you slice it, getting a tax refund is not the best economic use of your precious resource known as cash. But it’s clear that the vast majority of Americans will continue to love their tax refunds. My hope in writing this article is that after reading this, you can now see the economic benefits of saving NO to the tax refund!