Why Tax Refunds are Bad

Tax season is here, and my employer’s W-2s faithfully arrived in the mail a few days ago. Curious to see how accurate my estimates throughout the year had been about my taxes, I logged in to my TurboTax account, and punched in the information. I quickly discovered that I would once again be getting a nice check from Uncle Sam come April, and was deeply disappointed.

Am I crazy? Nope, because tax refunds are bad!

If you do think I’m crazy, consider a few things first. There are certainly a lot of positive things to be said for tax refunds. In hard economic times like these, it might feel like a much-needed bonus for many people. Since many also don’t expect it, it will allow them to take vacations with their family, buy a new car, or shop for electronics. After all, it’s free money, right?

If you stop to actually think about what’s happening, it doesn’t take long to realize where the money is coming from. It’s yours! Would you go out and blow through the money if it was coming in your paycheck instead? The average tax refund in 2008 was almost $2,500. Assuming you get paid every other week, that’s almost $100 missing from every paycheck! If you are truly struggling, wouldn’t you rather have an extra $100 every other week, rather than getting a big chunk at the end of the year and spending it foolishly?

If you are still skeptical, consider the following two scenarios:

Large Tax Refund: You get a big tax refund in April 2009 ($2,500) and another in April 2010 ($2,500). You invest the first year it in a bond fund that returns 5% per year. How much will you have in April 2010? Including compound interest, about $5,127.

No Tax Refund: Instead of the big chunk at the end of both years, you get and save an extra $100 each paycheck in the same bond fund, returning 5% per year. How much will you have in two years (April 2010)? (Remember, we started saving in April 2008, because we didn’t have to wait for a refund to come). Again, including compound interest, about $5,246.

Granted, $119 may not seem like a large amount. But what if you’re dealing with much larger refunds than the average? Also consider the effect of doing this every single year for the rest of your life. And then add the magic of compound interest on the entire balance. Now we’re talking!

Most importantly, consider what you actually do with your tax refund every year. If you’re like many Americans, it’s very likely that the money is gone before April even comes to a close, and you are left wondering how this large windfall you received disappeared so quickly. If you have the discipline to save the money every month, you will be better off in the end without giving a free loan to the government.

How do you go about figuring out what you should pay? If you are already using software like Quicken, it has a built-in tax estimator that can help you figure out how close you will be to breaking even at the end of the year.

They work so well, in fact, that on last year’s taxes, I owed a total of $22 to the government. The fact that I owed money is irrelevant – what’s important is how close I came to accurately estimating my tax liability for the year. Getting married this year threw off my estimates, but thankfully did so in the positive direction. For 2009, I will be running the same simulations and targeting $0.

If are looking for an online solution, a great tool put out by the IRS is the Withholding Calculator. Inputting your expected income and deductions will return the number of allowances you should take on your W-4 form to achieve the smallest possible refund. Once you have an idea of where you stand, go to your employer, and ask to modify your W-4.

Don’t give Uncle Sam a free loan and keep the money you’re working for instead. If you think a big “bonus” is a psychological boost, just wait until the “raise” you get when you fix your taxes.

Photo by alancleaver_2000