Wednesday, April 18, 2007

Debunking the Myth That Tax Refunds Are Bad For You

Author: Nick
Category: Money
Topics:

how does your tax return stack up?

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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