Is a Bigger Tax Refund Better?

March 13, 2012

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Call me crazy, but about this time every year an image pops into my head of Paul Revere riding a horse, swinging a lantern, and screaming, “Your refund is coming!

Your refund is coming!” OK, so I know it’s greenbacks, not the British on their way, but what can I say? That’s just how my brain works. What about you, though? Does tax season fill you with anxiety or anticipation?

Because it’s tax time again you’ll most likely be confronted with one of these scenarios:

You didn’t have enough withheld so you’ve got to write a check to Uncle Sam.
You had just the right amount withheld and this tax season will be a non-event.
You had too much withheld and you’re getting a check.

As it turns out, the vast majority of us, including Team Halliwell this year, are in camp No. 3. According to the IRS website, for the past few years about 77% of tax filers received a refund of just about $3,000 on average. So I guess the natural question that follows this is pretty clear, “Is this a good thing?”

My answer: Maybe. Really Scott? Isn’t getting a big refund supposed to be a bad idea?

OK, let me address this point right up front. Yes, from a purely financial perspective, getting a big refund is a bad idea. And if you’re getting one, the most prudent course of action is to adjust your withholdings so that you receive very little or nothing back next time you file your taxes. After all, any money you get back when you file your taxes (except for refundable credits) is simply a return of the money you had withheld over the course of the year that exceeded the amount of your tax bill — without interest.

For example, if the tax bill calculated on your tax return is $7,600 but you had $10,000 withheld, you’ll get a $2,400 refund of your own money — not $2,400 plus interest. If instead, you had adjusted your withholdings so that you received that $200 per month in your paychecks, you could have saved this money on your own and earned some interest along the way (though admittedly very little in our current interest rate environment). The bottom line here is that financially speaking, it typically doesn’t make much sense to give the IRS an interest-free loan.

So, why then would I answer “maybe” to the question of whether or not a big tax refund is a good thing? Well, the answer is, there’s theory, and then there’s reality. And the reality is that for some people, the forced saving inherent in a larger-than-advisable refund is their best (if not only) real chance to actually get some money in the bank. Many people simply don’t have the discipline to save the money on their own or their life circumstances would make it very difficult to do so. In such cases, forced saving in the form of over-withholding on one’s taxes may just be a different way to achieve a good outcome.

Also, there may be non-financial reasons to set yourself up to get a refund. I’ll personally be getting one this year but it’s not for forced saving purposes. It’s because years ago there were several times when I had the unfortunate experience of having to write large checks at tax time. It felt awful and the feeling has never left me. So now I intentionally avoid that anxiety by making sure I get some back each year. For me, the missed interest is worth the trade.

However, if you’re one of the people in the forced saving camp, I have an important message for you: DON’T SPEND THE MONEY! (Or at least not all of it.) Keep some of it in the bank for life’s unexpected financial emergencies. Emergencies are going to happen, you’re going to need money when they do, and now you’ve got some put away to deal with them. Who knows? It may even work out that next year you’re not so eagerly awaiting that guy on the horse!