Debunking the Myth That Tax Refunds Are Bad For You
Author: Nick
Category: Money
Topics: taxes
Except for some victims of a recent tragedy, foul weather, or tax software company incompetence, most of us in the U.S. have filed our tax return (or automatic extension) and have a good idea of our tax bills for 2006.
Some people expecting a refund from the IRS count themselves as lucky–they’re getting “free money,” “an unexpected windfall,” or perhaps “a gift from the government.” Of course anybody who understands how money is made realizes that an income tax refund is simply the return to you of your own money. If you’re getting a refund, you had too many taxes withheld from your paychecks over the year. But the federal government is very appreciative of your interest-free loan. So appreciative, in fact, that they make you fill out pages and pages of forms to get that money back.
Certain personal finance writers who don’t know what they’re talking about will tell you that income tax refunds mean you screwed up. How dare you let the gubberment hang on to even a penny of your money longer than they should. You missed out on a couple hundred dollars in savings interest by not receiving that money throughout the year. Your stoopid with monie.
On the contrary, income tax refunds are probably good for you, the average American citizen. (Though if you’re reading this, you’re financially smarter than the average American, so you may be an exception to what I’m about to say.) The average Americans with their negative savings rates typically spend their entire paychecks. Adjusting their W-4s so that excess taxes aren’t taken out in the first place just means more money for typical Americans to spend right away.
But if those excess taxes instead accumulate in a government bank account, they form a bigger ball of money. And at tax return time, the typical American will be more inclined to save that “unexpected windfall” instead of spending it like they would have during the year. Sure they missed out on up to 12 months of interest, but at least they didn’t blow it all on a giant TV.
Income tax returns are a psychological mechanism for Americans to start saving. If I give you $3,650 in December, you are more likely to put that lump sum in a savings account than if I gave you $10 a day for the entire year. Large wads of cash are an invitation to save; mere nickels and dimes demand to be spent.
For the second straight year, I’m expecting a tax refund close to five figures. That’s because, once again, I screwed up by not adjusting my W-4 following a major life event. In 2005, I failed to adjust my W-4 after getting married, so my darling tax deduction–er, ahem, wife greatly raised my deductions. Last year, we bought a house, opening the door to all sorts of crazy itemized deductions.
But that’s okay, because every penny of my refund is going straight to savings. Would that money have ended up in savings anyway? Maybe about 20% of it (my target savings rate), but the other 80% would have been spent on my antique ukulele collection.
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53 Responses »
1.
broknowrchlatr
April 19th, 2007 at 7:20 am
In concept, you may be right.
There are MANY people who won’t save unless they are made to do so. For them, it initially seems like it is good to get a tax refund. There is an add for a Chase checkign account where whenever you use your debit card it rounds up to the nearest dollar and deposits the difference in your saving account. It is apparent that if this is a good system for anyone, the issue is that it is way too easy to get you to spend a little more than to get you to save on your own.
I think the problem comes at tax refund time. They get a big refund and then spend it on something they don’t need. Perfect example is car dealers offerring those “tax refund anticipation loans” where they calc your taxes and loan you that money for a car until you actually get the money. So, the issue is that the mentality that would tell you to save the refund is the same mentality that tells you it is better to get the money early and save it then. Now, if there were no tax refunds and the government put the money in an IRA for you, that would really help such people.
2.
Nick
April 19th, 2007 at 8:24 am
I think you’re on to something here, broknowrchlatr. But I doubt the federal government would ever go for such a plan because it would likely push more people to adjust their W-4s to avoid a refund. That means fewer interest-free loans.
But yeah, that would solve the negative savings rate of Americans pretty much overnight!
3.
Hazzard
April 19th, 2007 at 10:40 am
I’m afraid my cynical nature has to disagree with you on people saving more by getting it back in a lump sum. My experience has been watching everyone I know look like they won the lottery when they get their refund back. There are very few people that I know that would save the refund. I do agree that people reading PF Blogs are probably the most likely candidates to save the return, but for everyone else, there is just too much *BLING* that they can buy for their Cadillac Escalades.
4.
Nick
April 19th, 2007 at 10:53 am
I didn’t mean to imply that Punny Money readers are more likely to save a refund. In fact, Punny Money readers probably care more about their finances and adjust their W-4s to minimize or avoid a refund in the first place.
I wonder if there are some monthly statistics available on savings account deposits because I bet they would show moderate bumps in savings activity for April (tax refunds) and perhaps December (end-of-year bonuses, though perhaps negated by holiday spending).
5.
Poorer Than You
April 19th, 2007 at 5:53 pm
I’m still on the fence. I saw a family member receive a few thousand dollars in her refund this year. She’s used the money to fix her car (which really needed it), and says the rest goes to debt reduction. But then she goes shopping and buys things saying “I just got my refund, I can afford it.”
I’d rather see her get less back at tax time and set up automatic transfers to her savings over each paycheck. But I guess if she did that, she would no longer qualify as a typical American taxpayer.
6.
Jennifer
April 19th, 2007 at 10:00 pm
Great thought overall. I’ve seen both habits – big spending and saving (or taking care of long-put-off-needs like car repairs). I admit, we get big refunds because we receive Earned Income Credit. Now, we could set it up throughout the year to get Earned Income Credit back but I don’t like the thought of OWING if we didn’t qualify one year!
My husband works 2 part-time jobs and goes to graduate school, I stay home with our 3 (soon to be 4) kids. But I know that a better job opportunity could be coming anytime (I can dream right?) or that inherited property could sell and we might not be considered so low-income anymore. I try to look at what we’ve set aside tax wise and what we owe before the big deductions/credits and it’s usually about even. I think that’s what everyone should strive for!!
We usually set part (if not most) of our tax refund aside for savings, it usually helps keep us afloat throughout the year (out of credit card debt!!). It helps when we know a big expense (like baby) is coming.
FYI – for your W4 they give you an amount of deductions (or whatever it’s called) that you can take, we usually subtract 1 or 2 from that. Example – single put 0 deductions (though you could’ve taken one), married put 1 deduction, married with one child put 2 deductions. This approach seemed to work well for us to get some $ back at tax time but not too much.
7.
Hazzard
April 21st, 2007 at 12:35 pm
It would be somewhat fascinating to see savings account trends at certain times of the year. Of course, for every bump in savings account, statistics would probably show that there is a similiar decrease in the following months.
8.
The Sarcasticynic
April 22nd, 2007 at 10:20 am
Nick, I agree that that tired old cliche needs to be dropped. If interested, here’s what I had to say on the topic of interest-free loans to the government. Your comments are welcomed.
Interest-free Loans to the Gov’t
9.
Clever Dude
April 22nd, 2007 at 5:15 pm
Well, since it’s free money, you could use your return for our remodeling efforts, right?
10.
Nick
April 22nd, 2007 at 5:56 pm
Clever Dude,
Sure, if that remodeling includes a tunnel from our house to yours so we can use your pool anytime we like!
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MissSapphire
July 5th, 2010 at 12:08 pm
I agree with you, Hazzard. This statistics are made all time long, and they are seriously taken into account. To establish some account types, banks are doing a large research to find the right one so that they will keep on benefiting but you will also have the impression that it will be ideal for your. These systems are much more clever then many of us…
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American will be more inclined to save that “unexpected windfall” instead of spending it like they would have during the year.
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[...] Debunking the myth that tax refunds are bad for you I think the author has a point here. The majority of people out there are bad at saving. So having the government hold a chunk of their money (even at 0% interest) is better than them spending it frivolously throughout the year. Link [...]
Pingback by Debunking the myth that tax refunds are bad for you - Personal Finance Forums — April 19, 2007 @ 12:10 pm
[...] even though I often cry “interest-free loan to the government” on tax refunds (though sometimes I don’t), and even though I adjusted my W-4 numbers again this year, we’re still getting back over [...]
Pingback by Nick’s Adventures in Tax Land, 2007 Edition | Punny Money — March 24, 2008 @ 7:56 am
[...] Income tax returns are a psychological mechanism for Americans to start saving. Nick at Punny Money debunks the myth that tax refunds are bad for you: On the contrary, income tax refunds are probably [...]
Pingback by Queercents » Blog Archive » Did you get a tax refund? 3 ways to make a windfall pay at tax time. — April 20, 2009 @ 7:55 am