Tax Refunds Are Good For Most People, Because Most People Can’t Save
The average tax refund is $2,400 a year, and 74% of Americans get a tax refund. I’ll consider you average for argument’s sake. At today’s typical savings rate of 1%, you’re missing out on a whopping $12 bucks in interest income! Why $12, and not $24? It’s because you have to calculate the average balance of the year if you saved every $200/month payment diligently starting January 1st i.e. January $200, February $400, March $600 etc.
I’m definitely not a proponent of giving the government more money than they deserve, but missing out on $12 bucks in interest is something I can live with and so should you.
You have to ask yourself whether you have the discipline of saving that extra $200 a month, or using it to pay down debt. Most people are not disciplined enough to pay down debt and avoid buying junk. This is why we have such massive debt problems in the first place! The government is essentially helping you “go broke to win big” by protecting 75% of American tax payers from blowing $2,400 a year without even knowing it.
A SIMPLE GUIDELINE & SOME COOKIES
A good way to decide is to take emotion out of the equation and just use a simple ratio. If the expected increase in monthly cash flow is less than 10% of your monthly net cash flow, forget about it! The extra money isn’t going to make a difference in your lifestyle, but that extra nut at the end of the year will. Turn it around, most financial advisers recommend saving at least 10% of your yearly gross income towards retirement. For a small fee, the government is helping you get to that goal.
If you really want to know whether you’ll be able to save your extra monthly income, buy a bag of your favorite cookies. Place them on your bedside table every night for 1 week, and see if you can avoid eating them. Now imagine a bag of cookies appearing every 2 weeks or every month for an entire year. Let me know how it goes!
All year long you condition yourself to live on less. Come year-end, you’ll be happy you did!
Readers, what do you think the average person should do? What’s the biggest refund you’ve ever got, and were you happy?
Keiju,
Sam @ Financial Samurai – “Slicing Through Money’s Mysteries”
Follow on Twitter @FinancialSamura and subscribe to our RSS feed.
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I’m sort of torn. If he had a HUGE bag of cookies, would he not eat any? Or maybe he’d eat a few and then save the rest.
I think the rule should be: If you set up an automatic payment plan to pay off the debt or stick it in a savings account then you can and should decrease your withholdings and get the money now. If you don’t, then keep it until later.
Also, $12 isn’t the true value of having it early. What if your credit card accrues interest at a 20% rate? Then suddenly that number becomes much bigger. But if you’re not going to use that money to pay off debt, then you’re not getting anything out of it anyway.
Daniel´s last blog ..Your Negotiators Contest Sign Up!
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This problem highlights the fact that personal finance is also about the “personal” and not just about finance. It sounds like a nice refund works for Andy even if it does not make much rational sense. If he paid down high interest debt instead, the cost of accumulating a refund is a bit more than $12. Still, his personal traits may make the cost worth it.
Let me make another point by assuming that he increases his deductions and he owes money to the government when he files his taxes. Will he have the savings to pay the additional taxes? How will he feel getting “hit” like that? – By the looks of it, he won’t have money laying around and he will be pretty upset that he will have to come up with a junk of money quickly. Is the possibility of this worth it to him?
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@Daniel
Nope, can’t eat any cookies.
And if he has huge credit card balances at high rates, then one can argue he should definitely NOT try and rake in more money every month, cuz he’s shown his irresponsibility in the first place with money.
Gotta protect him from himself, like I do every single month :)
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I think this all depends on this person and their level of discipline. If they have the discipline to just automatically save the money, it makes sense to adjust your withholding. If not, let it ride and get the refund.
Peter´s last blog ..Traditional And Roth IRA Contribution Limits And Phase Outs
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To some extent it is an individual decision. Example-I’ve been on the wrong side of a battle with the IRS and vow never to go there again. On Jan 1st we don’t know what the future holds, job loss, job change, winning the lottery or catastrophic health issue; your tax situation could change en-route.
Personally, being debt free and having cash reserves, it’s worth giving up even $100 in lost interest income to have absolute confidence that they will owe me vs. me owing them.
LeanLifeCoach´s last blog ..Finance & Marriage – To Share Or Not To Share?
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What drives me nuts about people and their refunds is that they’re actually thankful for their refund like it is a gift. The reality is that it was your money and you overpaid the government.
The source of the problem is that we are numb to the withholding out of our paychecks. if everybody had to actually write the check for their taxes each year like a business owner, people would demand lower taxes.
20smoney´s last blog ..Sold Exxon Mobile (XOM) On Break Of Trend Line
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@20smoney
Vanguard has a nice article showing that people aren’t rational:
Why so many Americans are broke
Check out Money Mistake #2: Splurging with a windfall. For some reason, people treat bonuses and refunds differently.
Daniel´s last blog ..Your Negotiators Contest Sign Up!
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I OWE a little on my taxes most years(no, I don’t have a business). Only a few hundred bucks, but for me it’s totally worth not giving the govt. an interest-free loan :). I diligently save more than enough via automatic withdrawals.
I hypothesize that if people pay themselves first, not a problem. I have no problem with the cookies, but if I make home-made ice cream I tend to eat it all at once!
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I like the tax refund, but don’t look at it towards savings or what not. I look at it the same way as if I got money from my grandma on my birthday. Something unexpected and appreciate if it comes, but live my life like it won’t happen. I save regardless and the extra little interest makes no difference.
Craig´s last blog ..Tonight’s PF Twitter Chat is Canceled
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It’s nice to get a tax return, but it kills me to give Uncle Sam an interest-free loan every year. But I’m better off this way because I’m not the only one who has access to my checkings and savings and it protects a portion of my income from mysteriously disappearing :-(
But if you can be fiscally responsible that $2,400 means $200 a month, and if you set up an account at Sharebuilder and did dollar cost averaging you should be able to manage your money better than the Feds . However, you also run the risk of doing worse so I guess this would depend on your knowledge of investments and your tolerance for risk.
David @ MBA briefs´s last blog ..You, Inc.: 5 ways to manage your life more like a business
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If Andy is reading your blog we can also assume that he’s pretty smart and is actively looking to improve his finances. With that kind of dedication, resisting the cookies would be… easy as pie… er.. a cakewalk.. Ok, now I can hear my stomach growling thanks to all the food references!
thriftygal´s last blog ..Chance to make an easy $75
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What’s the difference if they piss it away a little every month or all at once after they get the refund. After all, if we’re talking about people that get large refunds, that’s usually what they do. The main problem with FS argument here is that he assumes they will save the tax refund. But every year we see stories like this…http://online.wsj.com/article/SB123966927473715515.html
I just ran a 2010 projection (what can I say, I’m a dorky CPA) and found out our refund would greatly increase since we’re having another child this year. So I lowered my Fed withholding from 1 to 3 and have about $75 extra bi-weekly that I’m automatically transferring to my Roth. I like to get my refund as close to -0- as possible.
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You’ve got a good point, especially with interest rates being so low now. But when they turn around it may be a difference of hundreds of dollars.
FinanceDad´s last blog ..13 must have iPhone applications for the frugal or money saving geek
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David – Good point if the checking account is accessed by more than one person!
Kevin – You’re right, and I purposefully left this argument out so we can argue that it’s all the same bc they’ll blow it come year end anyway on a fat 14 year old honda civic! :)
My argument is that it’s easier to NOT spend a big nut refund due to guilt, as well as the realization one doesn’t want to waste 12 months of “savings”.
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When I was younger, We once jumped up into a higher tax bracket (we both got raises), and were caught with our pants down. We ended up owning the gov. money that year.
Since then, I’ve always enter 0 allowances on the W-4…
Besides, I kind of like getting that big ole refund electronically deposited in my account. That plus the typical annual bonus I get for work, it’s like BOOYAH! It’s nice to see that money flow in :) I’m probably one of the only readers on your site that looks forward to doing it.
Don@MoneyReasons´s last blog ..Wealth Tip #3: Be Cheap, Don’t Show Off
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I agree with ctreit–this is one of the many areas in personal finance where you just need to understand your own tendencies and know which option works better for you.
We used to receive a big payout from Uncle Sam year after year ($3-$4K or more), and inevitably, it would disappear into the unknown within a month. Going with lower withholding throughout the year just worked out better for us.
Wojciech Kulicki´s last blog ..Should Kids in High School Work?
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@ctreit
I think more often than not, when people OWE money to the gov’t at the end of the either, they think “fook, that’s painful, down goes my savings” or whatever. I’d much rather have a refund than owe, yes, even if I could use it to invest elsewhere. If one did that in 2008 or 2009, they would have lost their shirts!
@Wojciech Kulicki
Good stuff Wojo. If you’re blow $3-4K in a month after you get your refund, then you might as well forget about it. Each their own.
@Daniel
Will check out the link. Thnx.
@FinanceDad
Don’t think the average tax refunder will miss out on hundreds of dollars in lost interest. MAYBE $100 if our savings yield gets to 4.2% based on the average $2,400 refund, but not hundreds.
Yes, if there’s crazy inflation, you want to get all the money you can from the gov’t and SPEND IT!
@Don@MoneyReasons
Booyah Jim! I mean Don! I like getting a 2nd bonus every year too. I know exactly how you feel.
@thriftygal
Key lime pie is my favorite. Yum, yum.
@Geek
Hah! Homemade icecream… hmmmm, sounds good, but actually once I see the ingredients put into all my favorite foods, I tend not to eat em again cuz it’s so unhealthy! You are a disciplined one. good for you!
@Peter
Yep. I think most people are not disciplined, including myself. Hence, “let it ride” and collect that refund at the beginning of the year!
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So true; good point. This is one of those topics where theory meets real life. Most Americans, at least, have very little fiscal discipline. Tax returns and year end bonuses pay for the summer vacation, debt from the holiday season and perhaps allow for some investment. Hadn’t thought of this angle til you brought it up; nice one.
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I usually end up owing on taxes, especially now that I have a business. I always pay enough estimated taxes to avoid penalties and I keep enough cash on hand to pay the taxes in full and on time, so I guess it works out. However, my goal for the coming year is to be a little more proactive with my tax planning and be a little more accurate up front.
Patrick´s last blog ..Should You Borrow Money to Fund a Retirement Account?
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@Sam,
LOL, actually when I hear BOOYAH, I hear it in my head as the cartoon character “Cyborg” from “Teen Titans” would says it (funny the influence my kids have on my vocabulary :)).
I confess though, occasionally (after the market has a bad day), I’ll watch “Mad Money’s Jim Cramer” just to see his take on what’s going on. He did a good job on calling the recession.
Thanks for pointing out the minimal gains from changing allowances on our W-4… I was thinking about changing mine this year, but now I think I’ll let it Slide…
Don@MoneyReasons´s last blog ..Wealth Tip #3: Be Cheap, Don’t Show Off
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I have slim to no discipline when it comes to sweets and my favorite cookies, so I’d definitely be in trouble there. As far as withholding, I’ve always kept my paycheck low to wait for the refund but I have always wondered about this topic esp. around tax season, so thanks for posting! Yeah, when you look at your example of a measly $12 loss in interest per year, why bother.
I agree it’s weird how getting a refund feels like a “gift” even though it’s my money in the first place. I’ve gotten in the habit though of putting my refund straight into my savings account or a CD so I’m not tempted to spend it. Having a lower paycheck per month also makes me work harder to control my spending during the year since I have less cash to work with.
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You’re assuming that he’ll save the money @ 1% … but what if he pays down a credit card that is at 19% interest?
Depending on your employer, you could automatically redirect the money into a savings account, to eliminate temptation. I do this, with the money going into my employer-run credit union. Not only is the interest rate always a lot higher than anywhere else (because employer pays all operating costs), but it’s a bit of an inconvenience to access the funds. Not a big deal, but it requires a phone call.
Kosmo @ The Casual Observer´s last blog ..We Could Have You Killed
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@Charlie
Good stuff Charlie. It does feel funny that a refund of our own money is like a gift, but that’s something we can’t deny, hence why not?
@Kosmo @ The Casual Observer
If he has debt on a 19% interest credit card then he definitely shouldn’t be given more money every month to get in trouble! He needs to change his spending mindset first.
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? By that argument, should he also not try to get a raise at work, since he shouldn’t be given more money every month to get into trouble?
Maybe he HAS changed his mindset, but still has debt hanging around.
In any case, there are probably a lot of alternatives that would get him better than a 1% return – even something as simple as paying down a car loan or mortgage.
Kosmo @ The Casual Observer´s last blog ..The Greatest Inventions of All Time
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Wow, so many great points in this case. At first, I was thinking is that extra $200 a month taking in the fact he gets taxed on it? Then you covered it w/ raising exemptions.
I am with Kosmo on this. If Andy has such big consumer debt he needs to take care of that before saving. Interest wise it makes much sense. Why save $12 if the debt interest is eating up X-fold amounts.
I enjoy getting a big refund. It is like being a kid in the candy store. But these past couple years I have diligently used it to pay down debt. A big chunk of moolah at one time on a debt feels awesome! Andy would benefit if he could do the same.
BTW, I think I would feel jipped if I didn’t receive a big tax return every year? But maybe just for a year, I will try doing it the other way. Hmmm…
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@Kosmo @ The Casual Observer
Going back to the title, let’s be realistic, if he has high interest credit card debt, a car loan, and/or a mortgage, he needs an entire make over and is not saving appropriately at all. Yes, he should go for a raise and create a bigger pie for himself. Giving him some of the crumbs every single monthy for him to eat is just pissing it away.
@Money Funk
Paying down debt is fine, but I don’t think most people, including myself have the discipline to pay down debt every single paycheck. Instead, lead it accumulate, and bam, pay it off in one big chunk. Then again, who knows what he’ll do.
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I have been on both sides of this one and I agree with Sam. Get the refund. It’s like a little savings program and much better than figuring out how to pay if you miscalculate and end up owing.
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I totally agree, Sam. I love tax refunds and most of my friends do too. It’s forced savings and unfortunately, a lot of people won’t save unless they’re forced to.
The good thing is, is that if you know you’re going to get a tax refund, you can change the amount of tax withheld or prepaid if you’re self employed. And that’s the point you were trying to make!
For MOST people (like you mentioned), who don’t save regularly, the tax withheld is forced savings for them. For everyone else, just change the amount of tax withhheld or prepaid.
Mike´s last blog ..Why having a HUGE Credit Score can Help You Make Thousands of Dollars: Everything You Ever Wanted to Know About Credit Scores
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No matter what one chooses to do it will only serve to magnify and not makeover their already existing spending habits.
A) The person that spends more than they earn on consumables and racks up credit card debt to buy stuff will just buy more stuff if they adjust their taxes withheld and receive more take home money in their paycheck/earnings.
B) The person who invests their money wisely into their business, portfolio, etc. will just invest more if they adjust their taxes withheld and receive more take home money in their paycheck/earnings.
Therefore, the person in scenario A will just continue to make themselves worse off the more money they have in their pocket unless they correct their spending habits while the person in scenario B will just continue to accelerate their wealth creation.
Credit Card Chaser´s last blog ..Are Credit Card Companies Evil if They Don’t Waive Fees on Haiti Donations?
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“Going back to the title, let’s be realistic, if he has high interest credit card debt, a car loan, and/or a mortgage, he needs an entire make over …”
Not trying to start a big argument, but seriously, if he had a mortgage, he needs an entire makeover? Quite a lot of people have a mortgage …
I guess where we disagree is that you assume he’d piss it away and I assume he’d do something useful with it. Does it really take that much discipline to pay off extra debt each month? I set up a recurring payment with my mortgage lender to pay extra money each month. In order to stop the extra debt from being paid down, I need to actively remove this.
Kosmo @ The Casual Observer´s last blog ..Ice Storm
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Hmm, I love the cookie analogy but I’m not sure it always holds. I’ve been known to keep cookies and the like in a secure outhouse to avoid eating them! But I’ve saved 30% of my income many years.
Where does this refund come from? Is it because in the us you all get taxed the same rate and then clawback later?
Or does the Goverment decide it doesn’t need the money? Okay, very funny you may think, but I got a tiny refund from my local council for that reason at Christmas.
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@ Monevatar – There are various tax rates based on incomes, as well as various deductions (exclusions from taxable income) and credits. Two people could make the exact same income and have a very different tax bill.
Government decides it doesn’t need the money? Now that’s funny :)
Kosmo @ The Casual Observer´s last blog ..Member Exclusive: The Professional
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I’ve always chosen to receive a rather large tax refund every year and give the government a free loan precisely because it is a guaranteed windfall for me every February. Do I miss out on an extra $100 or so interest? Yeah. But really, is that enough to make a strong case for NOT getting a rebate? I say no.
The other side of the coin is the additional withholding forces you to live more within your means.
Best,
Len
Len Penzo dot Com
Len Penzo´s last blog ..Black Coffee: My Favorite Blogs, Money News & Opinions #30
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@Kosmo @ The Casual Observer
Hi Kosmo – I’m talking about someone with all three: high CC debt, an auto loan, and a mortgage. If one has all three, I think there are bigger issues at hand and a shift needs to be made. Giving a credit addict more money to spend everything month is a sure fire way to piss it all away.
@Monevator
Ah, well.. you keep your cookies in an outhouse (yum), but the challenge is to keep the cookies on your bedside table. Good luck not eating one!
The refund comes about due to a convoluted tax structure we have here in the US. Deductions, exemptions, different marginal tax rates that give us all a headache. Flat tax is the way to go!
@Len Penzo
At today’s 1% savings rate, if you’re missing a $100 interest loss, that’s a nice $10,000 juicy refund a year! Still not that important if $850/month in extra month a month is less than 10% of your net monthly income though in my opinion.
admin´s last blog ..Creating Powerful Friends: Samurai’s Alexa Ranking Challenge
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@ Sam – That makes sense, assuming that they haven’t changed (and also assuming that they would similarly piss away a refund). My assumption was just that there was surely SOMETHING the money could be used for that would yield more than 1%.
The calculation is also slightly off, as it assumes you’d get your refund on Jan 1. Get your refund on March 30, and it’s up to 1.5% (as you have the $2400 @ 2% for and extra 0.25 years)
Kosmo @ The Casual Observer´s last blog ..Bold Predictions for 2010
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@Kosmo @ The Casual Observer
Believe it or not, there are some people who actually used their disposable income or tax refunds and invested in real estate and the stock markets in 2008 and got their face ripped off. I know everybody in the PF community are richer than ever before with this downturn, but investing cuts both ways.
Do you mind explaining me the calculation you are refering to? How did we get 2% for an extra 0.25 years? How did we get 2%? And if we always get our refund and pay our taxes on the same dates, isn’t that always a 12 month cycle? Thanks.
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I’m not saying that people didn’t piss their money, but it seems to me that someone who pisses away a small amount each paycheck might do the same with a large refund.
Sorry, that should have been 1% for an extra 0.25 years. Sure, we may get our refunds on the same date each year, but that’s not relevant. Extra money that I would have received in a check on Jan 1, 2009 that I end up receiving on March 30, 2010, that money is delayed 1.25 years (and money that I would have received on Dec 31, 2009 is delayed 0.25 years), and could have been earning interest for that time period. The fact that I received a refund last year at the same time doesn’t effect the money that I could have made with this year’s money.
Well, I’ll shut up now – I’ve said enough on this topic :)
Kosmo @ The Casual Observer´s last blog ..Bold Predictions for 2010
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Huh, I’ve never thought about it that way – wise observation. The wife and I are using our refunds this year to travel to Turkey, and there’s no way we would have had the discipline to save up enough if the government hadn’t forced us. We would have *gasp* ended up using credit cards to make up the difference when the time to buy the tickets came around. So, I guess I should renounce my previous criticism of the gov’t geting an interest-free loan at my expense.
I do think though where the refund is particularly painful is when someone loses their job halfway through the year. That’s a time when the money could be the most useful, and assuming they don’t find a new job for a few months, their refund should be larger. Too bad there’s not a mechanism to access it sooner (not sure how early you can get those instant refund checks from places like H&R block?).
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admin Reply:
April 2nd, 2010 at 1:03 pm
I don’t like a lot of things about the gov’t, but I’m willing to forgo an extra $12-24bucks of interest income a year. Keep that money away from me so that I adapt to spending less money a year all year.
Good point about unemployment halfway. However, hopefully one is used to the lower amount of income and has saved accordingly.
admin´s last blog ..Riding Rocketships For Greater Success
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Yeah, I couldn’t save if my life depended on it, it’s so tough to look ahead and not just live in the now! Thank god for tax refunds, but someday I hope to get over this difficulty of mine. :)
Chris´s last blog ..Bridgestone Motorcycle Tires
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I keep my W4 at a level where at the end of the year, I shouldn’t get a refund, nor owe the gubmint any extra taxes. I’m trying to tailor my lifestyle to be able to live on 50% of my takehome, and the other 50% goes towards debt prepayment.
If you are in an intense debt payoff mode, then this works great. If you have a ton of debt and don’t care about paying it off early, then by all means, let the IRS be your savings account.
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I know there are penalties for underpaying taxes, but can you, for example, claim 10 allowances for the first 8 months of the year, and then have extra withholding held the last 4 months, giving you an 8 month interest-free loan?
Daniel´s last blog ..Introducing The Samurai Alexa Ranking Challenge
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admin Reply:
April 2nd, 2010 at 1:05 pm
I’m sure there’s a way Daniel-san, but I have no idea how to do that!
I have co-workers who purposefully underpay, or ask for an extension b/c they owe too much in taxes. The penalty is less than the savings/earnings they get so it’s worth it to them!
admin´s last blog ..Punctuality Breeds Credibility – Stop Being Late!
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Hum, interesting topic. I’ve always heard to make your refund as small as possible, and I do think it makes sense if you are good at managing your money and will use the larger paychecks you receive to increase your investing rather than your spending. That said, for most people, I think you’re right, FS; if they’re getting a $2400 ‘bonus’ once a year, it’s more likely that at least some of the money will make its way toward financially beneficial goals (put into an emergency fund or pay down a solid chunk of debt. Of course, most people reading your blog probably fall into the good financial manager category (or should once you whip them into shape), so we’re back to the first argument.
Short version: I can see either method working, depending on how your mind works.
Roger´s last blog ..Net Worth Update: Another Month Gone
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As painful as it is to give Uncle Sam the interest free loan, it is the best thing for 90% of Americans. Lets face it, for most the money would be gone anyway. At least it is a forced savings mechanism that gives you an opportunity to be wise just once. What you do with your refund mainly determines if it is good for you. In my blog i discuss my debt free path.
Dollars Not Debt´s last blog ..Do You Want to Be Wealthy? Three Very Simple Rules to Make You Rich
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I dont like the idea of overpaying the government then later getting the difference. There are lots of options out there for individuals who cant save like setting up an automatics allotment to mutual funds or a reitrement account.
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admin Reply:
April 2nd, 2010 at 1:07 pm
I don’t like the idea either Jay, but I face reality. The reality is most people can’t save for cookies. And this year, I owe several thousand, and that just sucks.
admin´s last blog ..Punctuality Breeds Credibility – Stop Being Late!
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Normally, I get a small refund, which is fine with me, but this year we’ve got the biggest deduction of all: a new house. We didn’t own it all of 2009, so I’ll have to see what the true numbers are next year and then adjust our withholding accordingly.
RainyDaySaver´s last blog ..Fix-It Friday: Our Home Improvement Wish List
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admin Reply:
April 2nd, 2010 at 4:59 pm
Ah, OK, yes. I love the mortgage tax shield. Shields up! It’s a good feeling, especially if you can comfortably afford the house! Congrats!
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I received a $9700 refund one year. That was too painful, so I got less deducted from my monthly pay. Boo on me for not requesting it prior to that.
Part way through the year, I usually do a simulation on my old tax software to see where I’ll come in at for the year.
One thing that I’ve done a couple of years is immediately put my refund into my RRSP as a contribution when it comes in (say around March or April) and then top it up to my max sometime around October. Fortunately in 2008, I didn’t do that in April, I threw the whole thing in in October. Just sheer lucky timing.
Single Mom Rich Mom´s last blog ..Do I REALLY need to work?
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found your site on del.icio.us today and really liked it.. i bookmarked it and will be back to check it out some more later
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