Fribble Thursday, January 13, 2000

The Wisdom of Tax Refunds

By ssarratt

Tax season is upon us, and many of us are looking forward to our tax refunds. Simply put, a tax refund is the return of some of the money that has been paid to the government the previous year. Because no interest is earned on this amount, the taxpayer is essentially providing an interest-free loan. At first glance, many people and financial planners consider this to be a bad thing, as a risk-free five percent on the money could be generated simply by stashing it in a savings account.

Say, for instance, that the tax refund is $1200. This is enough money to do something with, such as purchasing stock at a discount brokerage or taking an inexpensive vacation. So instead of waiting for the refund, one option could be to save the money over the course of a year by transferring $100 a month from a checking account to a savings account. Then at the end of the year, the same $1200 plus interest would be available.

The interest earned would be based on the average balance and the interest rate. The average balance would be $600, zero on day one and $1200 at the end of the year. At five percent simple interest, the account would earn $30. Taxes would have to be paid on the interest. So at a combined 33% tax rate, the individual would be left with about $20 net interest for his trouble.

There are several risks with saving the money. The first is that the cash is available to the taxpayer, making it tempting just to spend it. This is especially true if the $100 is kept in checking until the transfer is made manually. One night on the town and the interest and a considerable part of the savings could easily be spent. Automating the monthly transfer is a far better choice, but once again the money is still sitting there in savings. Even this has a downside as the individual needs to keep track of the money. One miscalculation and, boom, there goes $25 in fees for a bounced check.

There are a couple of benefits to overpaying one's taxes. Foremost is avoiding the pain of actually writing a check to the IRS at tax time. Another is the fact that capital gains and interest earned are not normally subject to withholdings. By planning to overpay, a cushion is established against additional taxes. Then if some stocks are sold for a profit during the year, capital gains taxes have already been set aside. Another benefit is that once the government gets the money, the taxpayer cannot inadvertently spend it.

Overpaying one's taxes in hopes of receiving a tax refund is akin to an automated saving plan -- but one that doesn't pay interest. The downside is the interest forgone. However, in the example given, the net interest is only $20 -- pocket change. There is considerable risk that sometime during the year, more than $20 of the savings would be spent, leaving the taxpayer with less money than the refund. The plus side is that, after a year, a significant sum of money, with no effort or risk, can be expected. The lost interest can be a fair trade-off for some people for the benefit of receiving a lump sum of money back at the end of the year.