So I’ve been struggling for a while with the idea of discouraging big tax refunds. Every time it comes up, people get all fired up that they don’t want to give an interest-free loan to the government, which is, of course, exactly what a tax refund is. They’re returning money you overpaid to them throughout the year. The problem I had is that I never thought it was a terrible thing. I saw (and continue to see) it as forced savings with a pretty low cost.
Let’s talk about that “interest-free loan” for a minute. First of all, you don’t earn any interest at all unless you’re actually saving that money every month. And even if you are, how much interest are you going to earn on an extra, let’s say, $150 per month (reducing your tax refund by $1,800 per year)? As of today, the interest rate on my savings account is 0.10%. One-tenth of one percent interest. That’s 1.25 cents of interest per month, or 15 cents per year on each extra monthly $150. I consider that a pretty low cost.
Second, as I said, you’re not really foregoing any interest if you’re not saving that money. Now, if you reduce your withholdings to take home an extra $150 per month, and then set up an automatic transfer to pay down debt, or contribute that money into a retirement or college savings account, then yes, I agree that that makes more sense than getting it all the following year. But the truth is that most of us don’t do that. If our take-home pay goes up, we find a way to spend it. Most of us don’t have the discipline to save that money. Which of these are you more likely to spend wisely: $75 in every paycheck or an $1,800 lump-sum?
I’ve recently become very interested in behavioral finance – the crazy ways we act that defy reason and rationality. Understanding a lot of these concepts can help us make better financial decisions – things like automating our savings contributions and timing 401(k) increases to an annual salary increase so we don’t even really notice it. In reading a behavioral finance book recently, I was so pleased to see that I’m right – people tend to find it easier to save from a lump-sum payment or windfall than they do from regular income. And the larger the payment, the more likely it is that people will save rather than spend it.
I’m not saying that you should be getting a huge refund from the government every year, especially if you’re struggling with monthly expenses and could really use that money (and extra-especially if you’re going into debt on a regular basis). But if you regularly get back $3,000-$5,000 every March or April from the government, and you find that it works for you to use that lump-sum to pay down debt or to bolster a savings goal every year, don’t let anyone tell you that you shouldn’t be doing that.