We filed our taxes back in February and received our federal tax refund back via direct deposit very quickly.
Our refund was large.
Much more than I expected.
And it didn’t bother me one bit.
Large Tax Refunds Used to Really Irritate Me
As in makemesomadIcouldscream.
I hated giving the government my money as an interest-free loan. I wanted to have that money in my pocket working for me rather than working for them.
Last year during tax season I had this to say:
The middle of the spectrum — the black line — is owing $0 additional in taxes and getting $0 back as a refund. This is the best result possible because it means you haven’t loaned the government your money for free, but you also don’t have to come out of pocket to make up the difference. All the money you put in your bank account and spent throughout the year is yours to keep.
I still love that thin black line. But now I realize it is practically impossible to reach.
Large Tax Refunds are Still Dumb
Don’t get me wrong. I still think getting a $5,000 refund back from your tax return is incredibly dumb. You’re still giving control of your money to the government until you file your return.
(Might I also add that you are trusting you’ll actually end up getting the money back before the Treasury defaults on everything… but if that happens I’m sure we will all have greater problems than getting our tax refunds back!)
As I wrapped up my taxes this year and discovered we would be getting a larger than expected refund I had to stop myself for a minute. Even though I let the government borrow a lot of money for free… was the impact that significant?
Calculate Interest Lost to Tax Refund
Running with this example, let’s say you ended up with exactly $5,000 coming back to you from the federal government. What sort of financial loss have you experienced in interest lost?
The easiest calculation is just to take the entire balance of $5,000 and multiply by whatever rate of return you could have earned during the year.
$5,000 in…
- your ING account (1.10%) = $55 in interest
- a solid rewards checking account (4.0%) = $200
- Vanguard’s Total Stock Market ETF (returned 30.12% in 2009) = $1,506
Wow. That looks like a lot of money.
Reality? The above numbers are meaningless.
Most People Wouldn’t Save Their Refund Throughout the Year
Let’s say the government decided to give your refund back to you, but in monthly payments rather than a lump sum. Instead of getting $5,000 you would get $416.66 for 12 months.
Sounds great, right?
The truth is most Americans out there wouldn’t be diligent with saving that refund throughout the year. The money would be innocently and quietly spent every month. Very little of it would be set aside for goals, retirement, or traveling abroad.
That’s not good.
In other words not only would you miss out on the big tax refund, but you would blow the money during the year and also miss out on the gains you could earn from having the money in a savings or investment account.
If you receive a massive tax refund I believe you are more likely to do something productive with the unexpected “windfall”. You’ll save it or pay down debt.
In fact many people I know have extra money withheld from each paycheck just for this purpose. (It’s kind of like setting up direct deposit to take some money out of your paycheck and put it into a savings account. Out of sight, out of mind. Except in this case you don’t control the account the money is sitting in.)
Alright readers, what’s your stance? Do you like getting a big refund, or do you adjust your withholdings to minimize your tax refund?
I for one like getting large tax refunds—I’ve heard and understand the “interest free loan to the government” argument. For me, I don’t mind providing this interest free loan…if it wasn’t for government funding, I could be speaking German right now…one quick example of how it worked out in our favor. Late 2009 we found out we were having twins (we already had one child)…we decided that we needed a mini van. With the big 2009 refund (which of course came in Feb 2010) we were able to pay the balance of the mini van loan and avoid taking out a car loan. There is no way we would have had that money otherwise. I like big refunds for the unexpected costs that come up…and if they don’t, then getting that big money back is extra padding.
Rather than relying on the federal income tax system as a forced savings tool, why not enroll in a company 401(k) plan especially if it matches, or ask payroll to split your pay check into checking and a savings account. The money is automatically diverted from your source of income, but also available to you for emergencies. With the income tax approach, you don’t have that money and then may rely on credit to get by.
Our refund is fairly large when you add in my school deductions. This last refund was our largest yet, and some of that money is *still* in our savings account. (Albeit very little, it went to pay for our Myrtle Beach trip earlier in the year and to help cover moving expenses this past month, so it’s pretty skinny now.)
That said, I really like it… I’m not bad at saving, but my husband isn’t too fond of it. He’s also fairly impatient, so having instances when he can blow a fairly substantial amount ($1k or so) makes him happier than waiting three months to do the same thing.
Plus I have to say I like living on “less” during the year and still managing to save a substantial amount, then getting the tax refund on top of it. More money every month would definitely disappear here!
I think it depends on each individual’s situation. For some people, they are barely scraping by. Without that bump in monthly income, they might accrue late fees or interest on credit cards, because they cannot pay everything off all at once. These individuals do not benefit by getting a tax return at the end of the year – they need that money now.
Additionally, sometimes there are lifestyle changes that dictate more money now (say, home ownership and a mortgage that’s higher than rent … or having children that requires daycare costs … etc.). Again, in these instances, I think the larger monthly income would help.
That said, I’ve always been very happy to receive a sizable tax refund each year, because, as you suggested, I tend to save it, pay down debt, make smarter decisions with that money than if I had it in smaller batches throughout the year.
Two points, neither of which is related to the question you ask at the end.
– It’s a bit hard for the US Treasury to default, as the dollar is held in reserve by most world governments. This is part of why the US could run up a greater trade deficit than other countries without such an immediate impact. If the Treasury defaults, the dollar goes with it, and we’d probably be looking at such a large collapse of the global economic system that this really wouldn’t matter.
– People may be less likely to spend a large refund (which I’m not sure about already as they may just buy a large expensive item), but studies show that people may not be as happy. One of the tenets of prospect theory is a diminishing return the further you move from the reference point. As such, 10 small gains feel better than one large one. This may not be immediately evident here given the large temporal gap between the payouts, but I still think it’s worth mentioning. Particularly since you started this post with a discussion about how you feel about the refund. This may not hold for everyone, but I think it’s important to acknowledge the influence our psychology has on our perception of this situation. After all, we often claim to be more rational than we are.
To your first point, I definitely agree. If the US defaults on our debts we have much bigger problems than getting our refunds back.
To the second point, I see your point about multiple smaller payments feeling better than one huge refund. My concern here is that a large chunk of the population is living paycheck to paycheck (some studies say 50%, some say 70%, either way it is a lot of people). A lack of income, financial discipline, or both has led them to that situation — happy or not.
You would think getting that extra money back during each month would help these folks out — perhaps they could stop living check to check. But if they are already living check to check I think there is significant risk of “lifestyle inflation” occurring. That is, instead of paying down that debt or building an emergency fund, they’ll turn around and spend a majority of that “extra” monthly cash.
Maybe that spending makes them happy in the short run, but they would be better served by saving/paying down debt/etc. to move the focus to longer term happiness.
Not only would most people not save the amount they get in tax refunds, but your interest/gains calculations make a pretty giant — and erroneous — assumption. You only get that money if and *only if* the entire $5,000 is in those accounts at the *beginning* of the year. So the equivalent saving in an ING account over the year would get about $22. The rewards checking would only get that 4% interest if you jump through all the hoops required to get it, and even then you only get about $100; more likely your return will be lower as you get a 0% rate some months on technicalities. And of course the return on stocks is volitile, so it takes way too much spreadsheet crunching to determine what the yield could have been, and you could have just as easily lost a ton of money there.
Simply put, at the amounts we are talking about with tax refunds, you are better off just making sure you overpay a little. That makes your chances of an unexpected bill at the end of the year much smaller, and the amount of effort spent to micromanage such small amounts of money really is not worth it. And really, sweating the details like that seems like a very Templated thing to do.
I agree that the calculations aren’t perfect — I could have set up a spreadsheet, divided the $5,000 out over 52 weeks, and calculated interest gained that way. But that is complicated both to do and to explain succinctly in a post.
I think by overestimating what you could earn the point is even more clear, don’t you? So you won’t earn as much interest, and most people are unlikely to save the money in the first place.)
Although I do disagree on the reward checking account. We just opened up our second account with a local bank paying 3.61% for what boils down to online statements and 10 debit card transactions per month. Very easy to do and the return is 3x as much as the “high yield” online saving accounts out there. (Although I know there are some banks out there that try to get out of things on technicalities. Thankfully ours is awesome.)
I dislike large tax refunds. I prefer a refund to having to pay, but too large of one is just frustrating, as you mentioned.
Generally, my wife and I do a pretty good job of getting a not-too-large refund each year. One of us pays extra taxes at our job, and the other takes all the deductions, so that they generally even out.