Tax Refunds Reframed
Is it good to get a tax refund?
Mathematically or rationally? NOPE! Almost all refunds are just a return of taxes you overpaid, which you lent to the government for free.
I have news for you though. Humans aren’t as rational as we like to think we are, especially when it comes to money. (See Nobel Prize recipients)[i]
So, the question now becomes is it good for you? This depends on many things like your personality, your habits, things like mental accounting[ii], and how you manage your budget.
Since there’s so much gray area here rather than trying to give an answer that’s specific to you, which is impossible in an article, I’ll give you a hypothetical example of a great way to use a refund and a terrible way to use a refund.
Make sure to keep reading, because I’ll also tell you why this question became so much more important over the last year.
Here’s a perfectly reasonable use of a tax refund:
Forced “savings”. Now, this does rely on mental accounting, you could divert a portion of each paycheck to a separate account to get the same results you do by over withholding (or at least you can when interest rates are ne. For some people saving is hard, and tax refunds can be a way to build in “savings” so you can almost treat the refund as a bonus. Maybe you use it for something fun, a vacation, a live show what have you. There are absolutely people out there who can manage their budget, withhold more than they should and use their refunds for stuff they “want” but don’t “need”.
Is this the optimal way to save? Nope. Is it rational? Not really (even if you can rationalize it). However, we humans don’t always act rationally especially when it comes to money, so if you’re saving money you otherwise wouldn’t and using it as a reward and that works for you, that’s fine. Don’t let perfection be the enemy of good[iii].
Here’s a horrible use of a tax refund:
To pay off your credit card debt from the prior 12 months. Or really any debt that could have been avoided without excessive withholding. I have seen people do this and it blows my mind, the extra taxes you “lent” the government earn you no interest while credit card companies are charging you upwards of 15% and now often times into the 20% range. This certainly isn’t rational, but it isn’t even reasonable.
Credit cards should really be used for things you can pay off at the end of the month, it’s not impossible to have legitimate uses besides that, but it’s highly unlikely. Credit card debt can be insidious, in most cases if you have credit card debt and are looking to get your financial life in order then getting rid of that debt is the best first move.
Paying credit card interest only benefits the credit card company, it doesn’t help you build credit and should be avoided if possible.
If you have small amounts of debt you accumulate each year simply because you’re withholding too much for taxes you have a huge opportunity to improve your cash flow.
Why is this more important than ever?
Two big things have changed the math on tax refunds significantly over the past year or so. Inflation and interest rates are way higher than they had been.
In other words:
Stuff is more expensive. Maybe you could make ends meet until you got the refund in prior years but suddenly you can’t. That’s a problem brought on by inflation.
Bank accounts were paying next to nothing in interest a year ago, so it wasn’t like you could have been doing much better with the money you lent the government without taking on a bunch of risk. Now, with interest rates way higher, that money could be doing something better, without taking much risk[iv]. The opportunity cost[v] of loaning the government interest free money increases significantly as interest rates rise.
Tax time is a great time to take a look at your budget and withholdings and getter a better idea of your cashflows. There are so many variables at play that it’s really best to seek the advice of professionals. Discussing if you should adjust your withholdings to make ends meet instead of getting a refund is a bigger deal today than it has been for a very long time. While we do not provide tax advice, we are happy to collaborate with you and your tax professional to see if we can help you on your journey.
Photo by Kelly Sikkema on Unsplash
[i] https://www.apa.org/monitor/dec02/nobel.html https://www.nobelprize.org/prizes/economic-sciences/2013/shiller/facts/ https://www.nobelprize.org/prizes/economic-sciences/2017/thaler/facts/
[iii] https://cdlib.org/cdlinfo/2010/06/02/the-perfect-is-the-enemy-of-the-good/#:~:text=We%20often%20quote%20Voltaire%3A%20%E2%80%9CThe,on%20excellence%20rather%20than%20perfection. (Paraphrasing a quote typically attributed to Voltaire)
[iv] https://www.fdic.gov/ (I’ll write something on the banks soon. It’s best practice to make sure your bank accounts are fully insured.)