Do you look forward to filing your taxes each year, in anticipation that the IRS will send you a big “tax refund” that you can then use to go on a spending spree, or pay for a vacation, or maybe even to pay off some debt?
Sorry, but … you’re an idiot.
First, let’s re-define our terms. Your “tax refund” isn’t really a refund of any taxes you paid.
In other words, getting a tax refund doesn’t lower the amount of taxes you pay. What you owe in taxes is what you owe in taxes, based on your income, number of children you have, the mortgage interest you paid, and so on. Getting a refund doesn’t reduce your tax bill by a single cent. Money to pay taxes is withheld from your paycheck. If too much is withheld, then the extra amount is refunded.
Your “tax refund” is actually the amount you overpaid. For example, you owed the IRS $10,000, but you paid $12,000. So you get back $2,000. This happens because too much money was deducted for tax payments from every paycheck you received during the previous year.
It’s not a “tax refund”, it’s a “tax overpayment refund”.
Some people mistakenly believe that getting a “tax refund” is a good way to save money. Although many people spend their refund as soon as they receive it. These people need to develop some financial discipline and learn the lesson of “pay yourself first” and not rely on refunded overpayments to fund their savings.
If you’re one of the people who think getting your so-called “tax refund” is a good way to save, think of it this way. Suppose a bank offered a “Refund” savings account with these terms:
- Money is deducted from every paycheck
- You can’t have any of the money that is deducted during a given year until some time between February and May of the next year
- You must complete a complicated “Refund” form to request your money
- After you submit the form, your money will be sent to you whenever they get around to it, maybe in a few (or more) weeks
- If you make a mistake on your “Refund” form, you will wait longer to get your money
- If you or your spouse are behind in any payments you owe to the government (such as a student loan), it will be deducted from your “Refund”
- Your money, which haven’t been able to use for more than 6 months (on average), will earn absolutely NOTHING (zero, nada, zilch) in interest or dividends
Does that sound like a good deal, like something you’d want to sign up for? If you think that’s a good way to save money, I’d love you to deposit your money in a new bank I’ll be starting …
When you deposit money in a real savings account at a credit union or bank, you receive interest (because they charge interest on loans they make with your money). So, you see, money on deposit is both “saving” and “lending”. You earn interest on your savings because you are lending your money to the bank and the bank is lending that money to others. But the money you get as a “tax refund” each year is money that you lent to the government for free — an interest-free loan to Uncle Sam. Why should you lend without receiving interest? Your interest-free loan to the government is the same as a zero-interest savings account.
If you’re smart, you adjust the amount of withholding (the money deducted from your paycheck and held by the government to be applied as payment of your taxes) so that the amount withheld is approximately equal to what you owe in taxes. If you get a refund of $200 or so because a little too much was withheld, or if you have to pay $200 because the amount withheld was a little too small, no big deal. (Note that you might get in trouble with the IRS if the amount withheld is either more than $1,000 less than the tax you owe or if it is less than 90% of the tax you owe.)
Let’s say you usually get a tax overpayment refund of $1,200 or more. If that’s the case, you would be better off getting that money in the form of $100 more in your paycheck(s) each month instead of a lump sum that comes in the year after you earned it.
If you have debt, you can add that extra $100 per month to your debt snowball. Why should you let interest charges accumulate on your credit-card debt as you wait for your “refund” of money that you used to make an interest-free loan to the government? That’s financial insanity. Get every dollar ASAP and pay off the debt more quickly!
If you don’t have any credit-card or similar debt, you can add that extra money to your emergency savings. The extra money you get each month will at least earn some interest for you and be ready for you to use in case you need it.
Or you could add the extra amount as an additional-principal payment to your mortgage. Even if you were going to do that when you received your refund in April, it will do more good and help you pay off your mortgage more quickly with less accumulated interest if the money is applied to the mortgage as soon as you earn it, instead of sometime months into the next year.
If you have no debt at all and you’re happy with what you have in short-term and medium-term savings, then you should consider adding the new addition to your paycheck to your 401-K or IRA. If you can do this automatically, so much the better. Instead of being detained as excessive withholding, it can go right to work earning interest and dividends for you.
Great information!