Your Refund Is An Opportunity Cost

Tax season is now over and if you get a refund from the government you’ve either already received it or know how much you’re getting.

I’ve written before about why getting a tax refund isn’t an optimal financial move.  When you get a refund from the government that means you paid too much in tax during the year.  It’s an opportunity cost.

That money was being taken from your paycheck and held from you, and inaccessible in case you needed it.  It was also being eroded by inflation since it wasn’t invested. 

Lastly, you wouldn’t give a bank an interest free loan, so why would you give one to the government? 

If you got a $6,000 tax refund this year it’s the same as buying a CD last year that pays nothing.  They take your money, hold it from you, and give the same amount back a year later. 

The market for CD’s that pay 0% isn’t good for a reason.  But wait, they give back less because inflation happened last year.  In 2018 that means the money lost 1.9% of it’s value. 

But historically inflation has averaged about 3.22%.

It seems the majority of personal finance bloggers defend the practice of getting refunds.  Many of those same bloggers write, very eloquently I would add, about how to save money and be frugal in life.  Tips on how to save $50 here, or $100 there. 

Some of these same bloggers have written online that the “interest free loan thing” doesn’t amount to that much.  I’m now going to show the numbers that it does matter, and when you get a refund you’re losing more money than you think. 

Recently I saw a back-forth about this issue on Twitter.  One blogger said that he usually gets about a $6,000 tax refund and he was upset that it’s smaller this year.  So I’m going to use the scenario of someone who gets $6,000 back in a tax refund. 

 

Break It Down

Let’s assume you’re paid twice a month at your job.  So the $6,000 extra the government took from you that they shouldn’t have comes out to $250 per paycheck ($6,000/24).  To keep the charts below smaller I’m going to show what happens monthly.  So Uncle Sam is taking $500 too much from you every month (2 paychecks), and giving you back $6,000 the following spring. 

The stock market averages 7% historically.  Inflation averages 3.22% historically.  I’ll use these two rates to show how money grows when invested and erodes when it’s doing nothing as they are standard averages to use over time. 

Below you see two scenarios.  In the first (Money Invested) you keep your $500 per month and have it automatically deposited in your VTSAX, which averages 7% annually.  When you break down a 7% annual return it comes to .5833% monthly.  You never see the money, it’s automatically invested.

In the second (Money Doing Nothing In Uncle Sam’s Hands) you give your $500 to the government monthly.  It sits and does nothing, it’s getting eroded by inflation.  At an annual average of 3.22%, inflation averages .26833% monthly.  You never see the money, it’s automatically taken. 

In both cases your net take-home pay is the same.  In one instance you auto-pay yourself into VTSAX (or whatever you like), in the other case you auto pay Uncle Sam (more than you should).

 

Month	Money Invested (7% annual Avg)	Money Doing Nothing In Uncle Sam’s Hands (-3.22% annual avg)	Difference
January	500.00	500.00	0.00
February	1002.92	998.66	4.26
March	1508.77	1495.98	12.79
April	2017.57	1991.96	25.60
May	2529.34	2486.62	42.72
June	3044.09	2979.95	64.14
July	3561.85	3471.95	89.89
August	4082.62	3962.63	119.99
September	4606.44	4452.00	154.43
October	5133.30	4940.06	193.25
November	5663.25	5426.80	236.45
December	6196.28	5912.24	284.04

Difference?  $284.04

But wait, we’re not done!  You actually don’t get your $6,000 back January 1st.  You have to wait until at least February 1st to file taxes and even if you file right away the earliest you’ll likely see your money is around March.  So your money keeps getting eroded by inflation into the next year.  Let’s see how the numbers are actually worse in reality. 

So when you get a $6,000 refund inflation has devalued that money to $5912 by December 31st.  Now let’s see how inflation erodes that even more calculated out until the following May.  That’s when you’d finally see it if you file on April 15th and get your refund late. 

This chart shows your invested money from the previous year as it keeps growing (but not adding anymore).  It also shows what you have left from your $6,000 as the government still keeps it from you.

Month	Money Invested (7% annual Avg)	Money Doing Nothing In Uncle Sam’s Hands (-3.22% annual avg)	Difference
December	6196.28	5912.24	284.04
January (following year)	6232.42	5896.38	336.05
February	6268.78	5880.56	388.22
March	6305.34	5864.78	440.56
April	6342.12	5849.04	493.08
May	6379.12	5833.35	545.76

Final difference if you get your money back in May?

$545.76

Now some may still say “eh, $546 bucks isn’t much”  To me, those people are out of touch with a reality in which the average median household income in America is $60,000.  I know if I have an unexpected $546 bill, I’m pissed.  Really pissed.  But if I could manage to save $546 on an item – perhaps an appliance, I’m ecstatic!  

And some of these same people blog about saving $50 on a grocery bill.

$546 is not an insignificant amount of money friends.  Not in the world I live in.

The opportunity cost of letting the government hold your money hostage from you is not trivial.  And if you think $546 is a lot, in years where the market has big gains such as 2017 (up 21.17%) the difference would be much much greater!

All you have to do to avoid this is adjust your W4 and get more in your paycheck now.  I saw one blogger say “But that forces me to make 24 good money decisions with the extra money instead of just one when I get a refund.”

Solution – have the extra money auto-deposited into your VTSAX account, and you’re done.  It only takes one good decision to fix this.  Auto-deposit.

And here’s an all too common reality about refunds – it only takes one weakness to blow the $6,000 refund and not save it.  “Dirtbikes are fun, spring is here….”

 

401K Implications

If you claim you can’t afford to max out your 401k, but still get a tax refund every year, that’s called “mixed messaging”.  You can obviously afford to lose more from each check than you need to since you’re giving extra to the the government and still living on your take home pay. 

All you have to do is adjust your W4 and put the extra money in your 401K.

 

Treat Your Investment Like A Refund

If you count on a tax refund every spring from the government to go on a vacation, you can get the same benefit by setting up an account at CIT Bank (currently 2.45% APY) or Ally and just have the excess taxes the government is taking from every check put into a high yield savings account.

That way it’s a bit more liquid than selling shares of VTSAX.  It probably won’t earn as much but you’ll still come out way ahead.  Then when you want to go on vacation you simply use the money.  You don’t have to wait for a refund, and you have hundreds of dollars more because it’s been invested. 

I’m not naive.  I realize that many who defend tax refunds will still not be swayed by seeing these numbers.  Sometimes people just get comfortable doing something and no amount of data or facts will change their mind.  I can’t say I’ve never done that before.  Personal finance is personal after all and I get it.

But I hope it’s opened your eyes to adjust your W4 withholding and at least try to get less of a refund to take advantage of your own money and invest it during the year.