The financial planning community is like many others. A fair amount of groupthink goes on, and we often try to boil issues down to their simplest forms instead of digging through the data and thinking things through from different perspectives.
Consider the question “Is it better to get a big tax refund, or is it better to make your refund as small as possible?”
The answer is not so simple. It depends on your familiarity with taxation and who you are as a saver and investor.
Is an “Interest-Free Loan to the Government” That Bad?
Here is the typical school of thought around tax refunds: You should strive to make your tax refund as low as possible, or even pay the IRS a small amount each year. If you get a big refund, it’s the same thing as giving the government an interest-free loan.
This is both correct and, practically speaking, naïve. As with any financial decision, we must take into consideration behavior and psychology, not just data.
Yes, if we get a big refund, we are giving the government an interest-free loan. But really, how much is the loan? Let’s take a fairly large $5,000 refund as an example.
Using 2% interest and keeping in mind that we are incrementally building up this $5,000 refund (that is, we are not just giving $5,000 in a lump sum to the government at the beginning of the year), the amount that you would give up over 15 months is only about $84.
This $84 would be your “interest-free loan to the government” from the time that you overpaid your first installment in January to the time when you got your tax refund in the following year around March or April.
So yes, you are giving the government free use of your money in this case, albeit a small amount.
Now let’s examine that numerical reality and add a dash of behavioral finance. The behavioral questions I would ask are:
If you were to not build up that refund, would you capture that hypothetical $5,000 ($192 per pay period) over the course of the year and save it?
Are you able to predict, with a high degree of certainty, your taxes due for the year ahead?
For most people, the answer is “no way,” even if you use a tax professional to prepare your taxes. A lot of financial changes happen in our lives that alter our tax outcomes every year.
As well, after-tax income that is paid into bank accounts is routinely and regularly used for day-to-day living expenses—not saved. That is, $5,000 divided over 26 pay periods per year is $192. A typical person would not stash away $192 into a savings account.
Even if you saved half of the amount, that’s still only $96 per month. For most people, I would guess that almost feels like treading water.
The Feel-Good Feeling of a Tax Return
If you receive a lump sum refund, not only does it feel good, but you may be more willing to save or invest a larger portion of that amount.
A recent survey by Credit Karma Tax revealed that 63% of the people surveyed will put their tax refund into a bank account or rainy-day fund or use the refund to pay down debt. Going back to my original question of capturing $192 per pay period, why wasn’t that money used throughout the year to pay down debt or save into a bank account?
Behavioral financial scientists agree that, while saving incremental amounts is good, a large increase in a savings or investment account feels a lot better than small changes over the course of a year. Simply put, it’s a bigger win, and who doesn’t like a big win?
A larger refund is also easier to divide into reasonable portions and strategize where those portions go, thus optimizing your savings. I agree that you can do this over the course of the year with your $192 per pay period, but again, for most people, it’s far too easy to spend that small amount on lifestyle expenses rather than saving it.
For Most People, Aim for the Tax Refund
Lastly, with the changes to our tax laws and to how payroll services is withholding taxes from earned income, in addition to a large amount of confusion about what is owed in tax by the end of the year, I would advise that most people aim for a larger refund.
Unless that refund is extraordinarily large in comparison with your overall income, I would argue (and this is coming from many years of experience in financial planning) that a larger refund is better and more easily optimized for savings and other financial strategies.
Far too many times, I’ve seen good, smart people try to walk the line of getting a small refund and end up being surprised negatively—and significantly—by a large tax bill. It doesn’t take a behavioral scientist to tell you that having to pay even a small amount of tax will hurt far, far more than giving the government a small, interest-free loan.
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