The following is a guest post from Michael at Money Beagle, who believes that a balanced approach to money management is the key to financial success. He blogs about many personal finance topics from getting out of debt to saving for retirement to tips on staying clutter free around the house, with an emphasis on ‘personal’.
There are many things that most personal finance bloggers agree upon: Saving is good. Credit card debt is no good. Retirement savings, absolutely. Borrowing from your 401(k), not so much.
One of the most commonly agreed upon pieces of advice I’ve seen is that you should strive not to get a tax refund. The rationale behind this advice is that you’re giving the government an interest free loan. The advice is to adjust your withholding so that you essentially divide your tax refund up among your paychecks throughout the year. If you stick that into savings, you get interest throughout the year.
Reading those items, it sounds like a no-brainer that everybody should follow this advice, right?
I say, not so fast.
If that’s the strategy you want to take, I say continue on. If you’re already taking this approach and have it down pat, then carry on.
But, if you’re getting a big refund on your 2011 taxes and are considering employing this strategy, I think there are better uses of your time.
Let me run through the reasons that I think having a tax refund is not a bad thing:
- The interest rate benefit isn’t there – As recently as a few years back, the main reason for arguing for the ‘no refund’ goal was because you were losing out on a lot of interest. If you got a $4,000 refund rates were 5%, you were effectively losing out on around $100 in interest (I calculated this by figuring 5% on $2,000, which is the ‘average’ amount your fund balance would have over the course of the year). Nowadays, interest rates on even the best savings accounts are 1%, so you’re looking at $20 in interest. I’m not sure that’s worth it, especially when you consider…
- Out of sight, out of mind – When you overpay on your contributions, you’re not only giving the government an interest free loan, you’re also preventing yourself from spending it. How many people would look at their growing balance over the course of the year, and give in to temptation and buy something at some point that you might not otherwise purchase? If the cost of whatever you buy is over $20 (using our example from the previous bullet point), you just killed the entire benefit of earning the extra interest.
- The big bang theory – Again, looking at the example of the $4,000 refund, if you get that refund, there’s a certain psychological high that goes along with doing something big with it. I’m talking doing something responsible here, like saving or paying down a debt. Seeing your emergency fund jump from $1,000 to $5,000 all at once, or seeing your student loan balance drop by a third with one click of the mouse will give you a rush, and can give you extra motivation on hitting your positive financial goals.
- You could miss – Tax codes and other things change all the time, so even if you adjust your withholding so that your expected tax refund goes to $0, you could end up with a change where you could get a refund anyways, or actually owe money. Granted, if you’re doing it right, you would have the money in an account to pay it, but what if you decided you were going to pay debt throughout the year and then had to scramble to get together the money to pay your shortage?
Don’t get me wrong. I don’t think that adjusting your withholding is a bad strategy. I just think there are better options of things that you can do with the precious time that you put toward improving your personal finances.
Do you typically get a tax refund? Do you take any actions in regards to your expected tax liability throughout the year?
As a guy who usually has to pay each year, I’d love to have this problem. In my time as a financial advisor, though, I’d say that your points focus on the less discussed half of the financial equation: human behavior. We should have a tax refund because we can’t trust ourselves to do the right thing with the money. Instead, get it at once and pay down a big bill or make that big purchase to increase our net worth (home improvement or investment).
I think the key to your discussion is actually a bigger one: when do we finally realize we continue hitting our head against the wall, doing the wrong thing with money, and begin making fundamentally sound choices? I say “we” because, although I tend to have good financial discipline, I still find myself making some bone-head calls (ask me about my investment in Sirius satellite radio…and I knew better at the time, too….).
Maybe the interest rate benefits aren’t there but what if this money was used to start a business or save for retirement? The sooner these activities occur, the larger the benefit will be at the end!
It only takes a few minutes to ballpark your withholding and the IRS even has a web site you can use to figure it out.
I don’t have an issue with over-withholding as long as it’s a *conscious* choice to do so and not a result of laziness!
You are right on. The interest rate benefit is simply not enough to make it worthwhile to risk owing at the end of the year. The few bucks I might make in interest does not outweigh getting a refund back every spring.
Yeah – I suppose if you’re just investing your money in a savings account it’s not really worth it. But, I like having the extra capital to invest in new businesses and investment opps. If you’re withholdings are off that could be several thousand dollars a year….
That being said, I agree with DollarD – if you’re making a conscious decision to save money by hiding it from yourself, go for it!
Sounds good as long as saver interest rates stay rock bottom, and the refund is actually used for, as Michael puts it, “something responsible.” I might relax the latter a bit though and say, for the example of a $4,000 refund, have a little fun with say $500 worth!
First, thanks to Squirrlers for hosting my guest post yesterday. Obligatory push to go check out my site 🙂
@AverageJoe – I have made more investing mistakes over my lifetime than I care to remember. I think we agree that focusing on improving those type of things is much more important than worrying about a little bit of money and whether you get it now or later.
@Dollar D – If you have an immediate need for it that can pay off down the road, that’s great. But, like anything else there’s risk. You could put it toward retirement and if the market tanks, you would have been better off leaving it in cash and investing maybe next year (when getting the refund). It’s a personal choice and again, I don’t think there’s a 100% right or wrong answer.
@Eric – Thanks for agreeing with me 🙂
@Kyle – Hiding it from yourself is definitely an intangible benefit that many don’t think of.
@Kurt – We put most of ours toward savings but we did leave some to go to our travel fund which I guess would be the ‘fun’. I do think that’s important.
Sounds really good..Its really nice to pay your taxes so that you dont have any hassle..
You raise a very good point regarding the lack of interest penalty for giving the Feds a loan.
“Out of sight, out of mind.” I never quite looked at it that way but, it does make sense. Almost like a type of savings account.
they are definitely not taboo Each year I receive few hundred dollars of tax refunds.