How Big is YOUR Refund?

I’m going to wax philosophical today on the subject of tax refunds.

One of the perennial issues that I discuss with my tax clients is the question, “I have a colleague who makes the same as I do, but he always gets a bigger tax refund.  Why is that?”  I don’t think the American Psychological Association has ever identified a malady known as “Refund Envy,” but I could certainly give them some excellent clinical examples.

Let’s start with the non-philosophical answer to that question.  A number of factors determine the size of your annual tax refund, and it’s certainly possible (even likely) that even though Taxpayer Smith and Taxpayer Jones have the same income, their refunds could be miles apart.  Smith might have an elderly mother for whom he provides support – and thus claims as a dependent.  Jones might have deductible interest from a second mortgage or be writing off prior year stock losses.

I’ll get into the blood gore and guts of managing your refund (specifically how to strategically use your Form W-4 Withholding Allowances Certificate) in a future post, but for now let’s talk about the relative merits of big tax refunds.

Nobody likes getting stuck with a big tax liability at the end of the year.  But at the same time, you shouldn’t necessarily assume that a big tax refund is a fate to be envied.  Remember this if you remember nothing else:  Your tax refund is not a gift and it’s not a prize – it’s your money.  Getting a refund simply means that the government has been holding on to your money all year, and now it’s time for them to return it.

Without paying any interest.

Think about a refund in this way, and suddenly that big, fat check doesn’t seem nearly as appealing.  A tax refund basically amounts to your giving the federal government an interest-free, short-term loan.  When you starting thinking about what that big, fat check could have accomplished as a big, fat annual contribution to your IRA, it’s enough to make you a little ill. 

But there are people who insist that avoiding any complications with the Internal Revenue Service for underpayment of their taxes is worth missing out on that additional income.  The thing is, the penalty for a slight underpayment of your taxes is not particularly steep, and there are multiple conditions under which the IRS will waive the penalty altogether.  Over time, some people forfeit thousands in addition income to avoid a one-time penalty of less than a hundred dollars.

Now all of this is not to suggest that, for some people, a large refund is the worst thing that could happen.  Some taxpayers know themselves well enough to understand that if they had an extra $200 per month in their paycheck, they would spend it all in no time flat.  And using an IRA or 401(k) contribution to save for a short-term financial goal like the down payment on a new car would be a bad idea – the tax and penalties for early distributions from an IRA would wipe out a good chunk of your nest egg.

Since very few banks offer Vacation Club or Christmas Club accounts (they went the way of a shiny toaster with a new checking account), and those that do offer interest rates of an astounding one-fifth of one percent, you could certainly argue that using your annual tax refund as an enforced savings plan is not the worst idea in the world.  It actually makes sense for the right person.

The point here is that your tax refund is your money, and you should use it in a way that’s beneficial and comfortable for you as an individual.  So what I’m really trying to say here is size doesn’t matter.

That last sentence was your reward for reading this blog all the way to the end!  Have a great day!