Rethinking the Tax Refund Argument

For many decades, tax accountants and financial planners have argued that overpaying your withholding during the year in order to get a big refund doesn't make financial sense.

if you underpay your estimated taxes, you may have to pay interest to the IRS. But if you overpay, you don't get any interest on your refund. Overpaying your withholding is like making an interest free loan to the IRS.

But a great many taxpaayers prefer to get a big refund because it's a pile of money that is often large enough to do something significant. They may use it to pay for a cruise or other kind of vacation. They might use it to buy some appliances or to make renovations in their home. Some of them will put it in the bank or a Section 529 plan to save for their children's future college expenses.

By contrast, it's difficult to do anything significant or satisfying with a few extra dollars each day or each week. A $3,000 refund will amount to $8.21 per day, $57.53 a week or $250 a month. In today's investment market, money market funds are paying about 1% interest. If the excess tax withholding was received each week and put in a savings account. it would generate about $15 of additional funds at the end of the year. However, that interest would be subject to income taxes. For a middle income taxpayer in a state that imposes income taxes, the tax would be close to 30% or $4.50 -- leaving a meager $11.50 of extra after tax money.

I've argued for over 40 years that getting a tax refund is wasteful. But when short term interest rates are below 1%, I can certainly understand why a lot of taxpayers prefer to overpay some taxes in order to get a bigger refund each year.

Making good financial decisions is important, but sometimes there are other important considerations.

Vern