Why and How to Avoid a Tax Refund

When you filed your tax return this year were you entitled to a refund? If so, was it a substantial one? Approximately 65-70% of all people who file a tax return are due a refund. The average refund for individuals from the IRS was $3,036 for the 2010 filing season! Why is that?

Many people think of their tax refund check every year as some type of bonus, and when the big check arrives in the mail or the money hits their bank account, it is often used for large purchases like a family vacation, home improvements or even to pay down credit card liability.

Income tax refunds are always a nice surprise after you file your taxes, but you could get a better return on your money. Had you not overpaid Uncle Sam over the course of the year and had instead invested the money you are now getting back, you would have had an even better financial gain.  There are a few benefits and drawbacks to obtaining a tax refund. However, arguably, overall, if you are receiving one then you are engaging in poor financial and tax planning.

Before you see the light that a tax refund is not in your best interests, let’s first look at some of the benefits:

1. A tax refund can act as a forced savings plan – Some people are just not savers and a tax refund can act as a savings plan.  According to AARP, only sixteen percent of Americans have saved enough money for retirement.
2. A tax refund can be used to reduce liability – This is similar to the forced savings plan idea. The National Retail Federation did a survey recently which stated that 41.9% of taxpayers receiving a refund this year are expected to pay down liability with it.

Now let’s look at some of the potential drawbacks of a tax refund:

1. You give the government an interest-free loan – If you are due a refund, then you are giving the IRS your money, with zero percent interest, for one year. You can do better than that with a checking account even at today’s low rates. Even if you get 1%, and you contribute $126.5 dollars every two weeks, you would end up with around $62 dollars or so by the end of the year. Do you want to give those $62 dollars to the IRS?
2. You end up paying more interest on the liability – If you wait until the end of the year to pay off liability, you incur more interest than you would otherwise. Say for example, you owe $3k on your credit card with a moderate interest rate (11%). If you were due a $3,036 refund, the $253 dollars a month you are giving the IRS could be going towards your credit card liability. As your credit card liability is paid down during the course of the year, you will accrue less interest than if you wait until the end of the year to make a one-time payment of $3,036.
3. The Opportunity Cost of Not Investing As the Money Becomes Available – With inflation picking up, the stock market is on its way up. You could put $253 a month into a ROTH IRA (if your income permits) or just a plain old Brokerage Account. Say you made 8% in your brokerage account by investing in different ETFs or Mutual Funds. You would have increased your brokerage account by approximately $149 dollars. Even if inflation eats the real gains, you are better off financially than if you gave the IRS an interest-free loan.

What You Can Do To Avoid A Tax Refund Next Year

If you did receive a sizable refund from Uncle Sam this year, you should highly consider changing your deductions on your paycheck to avoid handing over your hard earned money as an investment with no return. To help you determine how much you should be withholding, the IRS has a withholding calculator right on their website to assist you. You will be asked some questions pertaining to your income and other factors that impact your tax rate. You will then be told how many exemptions you should take. Additionally, if you have your taxes prepared by a tax accountant they can also advise you on what your withholdings should be. Be sure to check what your quarterly withholdings should actually be, as sometimes taxpayers end up with underpayment penalties which could kill any investment or interest gains by investing your money as you receive it.

After you have adjusted your withholdings, you can now take the additional $253.00 each month (or other amount depending on your return), and invest it. This is a critical step in order to make sure you are making a return on the money.

In conclusion, getting a tax refund, while exciting is not the best financial decision. Take the time now to make the adjustments and you can start keeping the financial interest on your income instead of giving it to the IRS for free.