I love getting a refund check from the tax man during tax season! Of course, whenever I say that, I almost always get chastised by somebody who tells me I’m crazy for feeling that way.
Indeed, most income tax experts advise us to take advantage of a tax-planning strategy that provides more take-home pay over the course of a year as opposed to a large annual refund. The conventional wisdom is that it’s better to increase your federal income tax withholding exemptions, which then results in higher take-home pay, which can then be invested in an interest-bearing savings account.
The fact is, most of us don’t get that much dough back from Uncle Sam to make a difference. For this reason I prefer to get a tax refund at the end of the year. If you carry no credit card debt and have your bills under control, then you may want to consider getting a refund too.
How much extra cash do you stand to lose each year by letting the tax man hold it?
Well, in 2014 the average US federal tax refund was about $2,831. With that in mind, using an online tax calculator, let’s assume you adjust your withholding allowance on your W-4 form to avoid a refund. If you placed that $2,831 into a one-year CD — where rates currently average about 1.1% — your cash would earn $31. Big deal. In essence, that $31 represents the opportunity cost of having a forced savings account.
Here’s the rub with CDs: The additional income you receive by increasing your exemptions is spread out incrementally across the entire 52 weeks. So most people put that cash into a traditional savings account paying a much lower interest rate instead. How much lower? Well, if you’re not a careful shopper, today you can easily find banks offering just 0.01% interest! Over the course of the year, that would return … 28 cents. I know.
The funny thing is there are countless banks and credit unions that still use the ubiquitous catch phrase “Watch your savings grow!” Frankly, an acorn transforms itself into a mighty oak in far less time. In fact, with the paltry rates banks are offering today, savers have to live to the ripe old age of 10,000 before they’ll see any results. But I digress.
Claiming fewer tax withholding exemptions is a great way for many people, especially those who are undisciplined, to maintain a forced savings account. It also offers a guaranteed windfall each spring that can be used to pay for big-ticket items or help meet long-term household financial strategic planning goals.
True, if you have high-interest credit card card debt, are having trouble paying your monthly bills, or expect an extremely large tax refund, then by all means increase your withholding exemptions so you can take advantage of the extra cash all year long.
Otherwise, there’s really no significant advantage either way. That is, unless inflation comes roaring back with a vengeance. Or you plan on living a long, long, long time.
Photo Credit: frankieleon
You will do much better to have some discipline save throughout the year and invest in something other than a cd. Invest in something like a mutual fund or individual stock.
To each his own, Jacob. The fact is, a lot of people don’t want the risk or don’t want to do the research that’s necessary to invest in stocks — especially in today’s over-priced markets.
Claiming more exemptions to have a higher net now is great in theory, but how many people actually invest that income? The fact is that the regular Joe isn’t going to do it, therefore it’s better to have Uncle Sam hold it for you — that is, as long as you don’t blow your tax refund every year on large purchases.
I agree, Ben. I think most people either tuck their refunds into their savings account or, more likely, spend it.
I am with you, I like my refund and I don’t care what anybody says. I usually take my refund and invest it anyways, but I don’t have to worry about having to owe money at the end of the year… even if it costs me a few dollars in interest.
Rather than invest it, the Honeybee and I usually spend ours on something — either to help pay for an upcoming vacation, or some big-ticket item we’ve had our eye on.
I have no problem with allowing the government to hold my refund for a few months for me. It’s the price of peace of mind.
As for spending that refund, my wife and I have a formula we use for bonuses and tax refunds: 25% to our travel budget, 25% to our savings, 25% to our pockets to spend how we want, and 25% to pay down the house or other debt (school in this case).
Very interesting, Michael! It like it!
Here’s our family formula for deciding how the refund money gets spent: 1 vote for me; 1 vote for Nina, 1 vote for Matthew, and 4 votes for the Honeybee. 😉
We’re very careful spenders, but I disagree with waiting for a refund. I don’t like the way the government spends my money, so why should I loan them more? It’ s like loaning a spendthrift relative the money. Sure you may get it back eventually, but why encourage irresponsible behavior?
Hmmm. You’ve got a point there, Olivia. But it’s not enough for me to change my ways! 🙂
This is a great article! But then I LOVE getting a refund back, so you’re kinda preaching to the choir.
By the way …. I feel so strongly about it, that I will even opt for a refund when I have credit card debt, like this year. The power of FORCED SAVINGS is just too great to pass up.
It certainly is a godsend for folks who can’t control their spending any other way, Ken.
I’m not the only one,Yeah! Since we have been terrible so long, I have used this forced savings to pay property taxes and town utility bills each year. With lots of deductions and such it is a head ache for us to figure it enough to get more back weekly. And then there was that year…1998…we owed like $1500. Never want that again! I’ll just take the refund. You are so right, the banks just don’t offer a better savings anyways.
Sadly, the banks today are racketeers. It is absolutely shameful that people are no longer fairly compensated any more for saving — in fact, after accounting for inflation, they are being punished with negative real interest rates.
The worst part is, over the long haul, these low interest rates are detrimental to our entire financial system.
I am with you, I love getting a my tax return in April. Yes I could be getting a little bit more (~$100) every two weeks on payday if using your numbers, but I would rather have a forced savings plan and at tax time BOOM! I can invest in something real. I can buy into that new mutual fund I have been looking at with the $2500 minimum initial investment, or I am 25% of the way to being able to buy some Vanguard admiral shares, or I can sock it away in a GIC and make less interest than inflation…. Regardless, I am ok with letting the government hold my money for a year, at the end of the day It will accrue 24 years of interest rather than 25 years if I was disciplined enough to invest that measly $100 extra a paycheck.
Also, the bigger the refund, the more recognition I get for my savings. With very minimal tax write offs here in Canada, the main driver for my tax return are RRSP contributions. The bigger the return the more it means I saved during the year.
For most of my working years I was like 99% of the other people in NA, I looked at it as the windfall it was and within a few days it was gone on nothing, probably partying for the most part. Now that I do my best to take hold of my personal finances 100% of it gets reinvested in something. Since I look at this money as a loan from my future retired self, all of the money goes back into investments, none of it turns into fun money. My wife on the other hand has about 10% of her return earmarked for spending.
Great post!
Thank you, Jeff!
We try to break even or owe each year. However, I do understand the forced savings some people like. However, if a person is having trouble living paycheck to paycheck during the year, they probably should adjust their withholding and get the money sooner so they can use it to pay living expenses.
Absolutely, Kathy. In that case, the forced savings serves no purpose, since there is most likely very little to save. In that case, the key is to try and reduce expenses as soon as possible.
I am also guilty of really liking a refund.
I use my tax refund for big ticket items. This year will be a new driveway. Next year will be solar power for the house. My wife has never met a dollar she doesn’t like to spend so this is my way to accumulate for the big ticket stuff.
P.S. How about an article on solar power and if it’s a good investment?
I’ve got the solar power for my house up right now, Mike. I’m just waiting for the inspector to approve it before flipping the switch. I’ll be reporting on the results later this summer.