Just Say No To A Tax Refund
#TheCreepyGuyIsPointingAtYou
Do you get a tax refund from the government every year? If so, why? You’re loaning them money, at no interest. Banks usually don’t loan you money at no interest, so why would you do it for the government?
For the sake of math, let’s just say you get $3000 back from Uncle Sam this year which is what the IRS claims is the average refund. That’s $3k extra that you allowed the government to borrow from you by taking it out of your paychecks last year. It’s your money. They then give you back the $3k in April or whenever you get your refund. They give you back only the $3k, nothing more. It was your money to begin with.
Now, if you didn’t allow them to do that by upping your exemptions on your W4, you could have been investing that $3k all last year. In case you’ve been under a rock, the market went up 21.17% last year. Uh.. yeah.
Opportunity Cost
So what did you lose? Well, you could say $3000 * .2117 = $635.10. But that’s not accurate because that assumes you had that $3k starting last January 1st and invested it all year long. The truth is the money would have accumulated paycheck by paycheck into your account during the year as the market went up and down up.
The calculations are too complicated in this hypothetical, but it’s safe to say you lost a lot of money! Not quite $635 But probably at least $200 – $300.
And oh yeah, that whole year while Uncle Sam took an interest free loan from you, inflation happened. So that $3000 that belongs to you – not only do you receive no interest, it’s actually worth less now in 2018 because inflation eroded some of it.
Inflation in 2017 was 1.6%. So now your $3000 is worth $2952.00.
Now, let’s say you do this every year for 30 years. What would your $300 of unrealized annual market gains accumulate to? Assuming a 7% annual market return…
$32,605.00
I realize the market won’t give returns every year like it did in 2017 so $300 might not be the most realistic number to use, but you get the picture. Compounding interest is your friend, and when you let Uncle Sam take free loans, you’re losing out.
I Don’t Get It
I’ve heard many people justify getting a tax refund by saying “it forces me to save”.
What they’re really saying is that they know their personality and that they’re probably incapable of saving money when they get it. So the only way to save is to not have the money come to them in the first place – to have Uncle Sam take too much out of their paycheck and give it back next year.
If this is you, what happens when you get that refund? Do you spend it anyway? What’s the point in playing this “forced savings” game with Uncle Sam if you’re gonna spend it anyway when you get it back? (with no interest)
If you do stash your refund away in a mutual fund or investment, then kudos. If that’s what it takes for you to save money, I’m not here to judge you. But remember that it’s not optimal, and you’re missing out on earnings.
And here’s the thing, if you want to set up a “forced savings” scenario because you’re incapable of saving money once you see it, then have automatic deductions go to your Vanguard account every check. It’s the same principle. But instead of the deductions going to Uncle Sam with no reward, you’re paying yourself.
Ok Sometimes I Get It
Some of you out there have very complicated tax situations, and being able to adjust your W4 appropriately to plan on not getting a refund is extremely difficult if not impossible. I get that.
You might have alimony, multiple rental houses, complicated business deductions, farm benefits, or overseas investments. Our tax code is so painfully complicated you can give the same scenario to 5 tax “experts” and get 5 different results. And sadly the new tax law did nothing to simplify it.
So if you have one of these complicated scenarios every year and you get a refund then you might just have to live with the reality that interest free loans to the government are part of your existence.
The best advice in this scenario would be to at least try to minimize how much that interest free loan is. If you err on the side of loaning Uncle Sam nothing, you might wind up having to pay extra when you file the following year. I’ve been doing that for over 20 years, and I just prepare for it by having money set aside.
In this case, I’m taking a loan from Uncle Sam, keeping it invested (ie, making money on it) and then paying him back with no interest.
So should you underpay like I do?
Turn The Tables
Note of caution here – if you do underpay you have to be careful to not go overboard! Yes, you can be penalized for underpaying too much. When do underpayment penalties kick in?
From the IRS website: “Generally, most taxpayers will avoid this penalty if they either owe less than $1,000 in tax after subtracting their withholding and refundable credits, or if they paid withholding and estimated tax of at least 90% of the tax for the current year or 100% of the tax shown on the return for the prior year, whichever is smaller. “
I’ve owed over $1000 in some years, but never paid the penalty because I’ve always paid well over 90% of what I owed, and usually 100% of my previous year.
What’s the sweet spot? Well as you can see playing a game with Uncle Sam and taking too much of an interest free loan can backfire. So depending on your income and how much you pay overall, my advice would be to shoot for underpaying by about $500 – $700 per year – only if you have a simple tax scenario and can calculate it accurately with deductions on your W4.
Of course you have to prepare to pay the remaining taxes the following year. If you keep that extra money invested in your VTSAX or even a decent savings account at a credit union, you’ll make extra on it. It’s basically leveraged investing.
I do the latter since cashing shares out of a mutual fund requires you to pay capital gains tax. Granted, the interest I get isn’t all that great these days, but my credit union is way better than the paltry rates at regular banks.
Chime in financial warriors – do you give Uncle Sam an interest free loan or take one from him?
Well, I accidentally gave Uncle Sam an interest free loan this year. First year as an attending physician, and figured I would owe taxes. Now that I know the situation, I’ll pay closer attention to how much tax we have paid throughout the year and adjust my W-2 as necessary at my main employer.
Of course, I am using The 10% Rule with the money I am getting back. Buying a much needed (Wanted?) gas grill and some stuff for my son’s new taekwando class. The rest of the money (unfortunately was $8000) is going straight into my student loans.
I also like the twist you put on it for the $300 that could have been invested, though I agree with you that the market will not always go up each year like it did this year. Still your point remains: If someone should be leveraging the interest on this money, it should be us and not the government!
I too used to get refunds early in my career until I wised up to it. Sounds like you’ve got a plan to turn the tables so kudos! Enjoy that gas grill!
You can get 1.5% rate using one of the online banks.
We ended up accidentally having a refund of $700 a couple of years ago, due to the Obamacare roll out. That same year we had fraud against our return, followed by Covered California failing to produce the right paperwork. Long story, but we just finally got that $700 back a few months ago. They did have to pay us interest though. Something like $50. Worst “investment” I ever made!
Sorry to hear about the fraud Susan but glad you got it back with interest. More than Uncle Sam does for most folks!
For the past few years we’ve owed Uncle Sam. Usually to the tune of a few thousand dollars. Somehow we offset a little of that by getting a refund from state (MD).
In 2017 we opened a Donor Advised Fund (DAF) and that turned the tables quite a bit. Looks like we will be getting a refund of around $5k. That DAF make a big difference!
The DAF is on my to-do list for sure. Thanks for the comment!
Absolutely give him a free loan. For two reasons – 1 pure complication to guesstimate what I can withhold. I am a W2, wife is a Schedule C (well now C-Corp for 2017 and S-Corp for 2018), I have a side law practice and throw on another 2 S-Corps for good luck. It is just impossible to know the profit and losses from the other entities.
More important than my personal situation – I think people can further better themselves with that one time lump sum of $3k (in your example) than the $57/week of income. Even if they spend two-thirds of it at least there is that $1k to do SOMETHING that helps their future self.
Thanks for the comment Evan and you’re actually agreeing with my post. I was clear in saying that I get it, some situations are too complex to calculate and thus would have to settle for giving the government the loan every year. That seems to be your situation so we agree.
I also clearly said that if someone uses the government as a “forced savings” mechanism – and they do save the refund, then kudos to them. But they are clearly not bettering themselves with that one lump sum if they do not save all of it since inflation is eroding it and they are not getting interest.
Additionally, as another commenter points out, many of the people who are getting refunds are likely not maxing out their 401k and IRA options since they obviously have a problem with savings.
Many people who force themselves to “save” by overpaying taxes don’t max out their 401K or IRA. I always encourage people to change their withholding, then put the difference into a tax-advantaged vehicle. The take-home pay will be the same, and you will still get some of those taxes back next year, because of the tax advantaged investing.
Great point and another reason why getting a refund is just a bad move. Inflation erodes the value of the money, you get no interest, and as you point out you could be putting it in a much better investment vehicle and earning interest & dividends.
Thanks for the comment!
I really liked that you not only brought up that people are essentially giving an interest free loan to the government, but also that INFLATION took affect on that loan.
I am more surprised by that day that most of my colleagues have no idea what inflation is. It is the deadly financial killer that non-investors never see. They only realize what it is when it’s to late, and they see their money lost purchasing power over the years.
I agree, it’s the silent burglar of your money. In essence, allowing the government to take your money like that for a year and then give it back the following April is the same as putting it under the mattress. That’s the kind of money that inflation eats.
Thanks Sean!
I’m going to owe quite a bit this year, probably at least $5,000. My blog income doubled last year and that was unexpected. I’m pretty sure we don’t have to pay the penalty because we paid 100% of taxes from last year. This year, I’ll have to start sending in estimated payments.
Wow – $5k. Yeah, you’re killing it with your blog Joe so you might have to adjust some numbers to keep things balanced. But that’s a great problem to have.
Thanks for the comment!
We underpaid our quarterly taxes in 2017 but not intentionally. We had an unanticipated payment from Mr. G’s pension attributed to 2017. It affected Obamacare and we’ll have to give a little back. It’s under $1,000 so no penalty should kick in. But the use of that word “generally” makes it sound as if the IRS is holding back on some exceptions they’re not sharing.
I thought the same thing – what weird guidance! It’s kinda like they’re saying “here’s the rule… depending on what mood we’re in, and underpayment is blah blah..”
We’ve owed Uncle Sam every year since we got married in 2011 and it was usually close to a couple thousand bucks annually. That was until last year when we claimed our 1 year old as a dependent and got a small refund for the first time($500). Claiming your kids as a dependent really helps by reducing the money you owe or even getting a small refund like I did.
You’ll have to adjust that back so you don’t overpay during the year. Remember, you can keep that money invested, but you have to keep it first!
Thanks for the comment!
I tend to get a few hundred back from both Uncle Sam and DC, which honestly I’ve been just fine with. I like lump sums which I can use to do useful things like paying off debt; I know there’s an opportunity cost to overpaying but I also like the psychological boost of being able to send more than $50-$100 at a time towards a financial goal.
However, the bulk of my refund last year was a property tax credit from DC because through some obscure calculation I was paying too much of my landlord’s property tax via my rent last year. I didn’t plan for that $1k refund nor could I adjust my withholding to avoid overpaying (and I suspect my landlord wouldn’t take kindly to me paying him $80 less per month to make up for it!), and I am so looking forward to getting that refund back again this year!
If it gives you a psychological boost then it’s probably worth it. An important part of getting to FI is feeling like you’re getting to FI. Mental state and attitude are huge, so if that works for you then it’s worth it. Just don’ let those amounts get too high 🙂