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That Tax Refund Is a Rip-Off

It's hard to beat the thrill of a windfall. In a typical year, as many as 75% of us will feel that rush, courtesy of the IRS. Recently, average refunds have come in just shy of $3,000.

Not that we have anything against checks made out in our name, but there are a few reasons to take a dim view of this annual financial rite of passage.

The worst investment ever
First, that check represents an interest-free loan to Uncle Sam -- $250 a month of your money that isn't earning squat in interest. A lot of taxpayers would rather over-withhold from their paychecks than owe the IRS come April. But consider the cost of doing so over the course of one year.

If the IRS were paying out measly checking-account rates of around 0.5%, you'd be able to pick up the tab for a few espressos -- or $7.50. Even if you could earn 4% from a high-yield savings account, it'd amount to just $60.

Nonplussed? We hear you. But we're committed to turning non-investors into shareholders, and we think the following results are pretty convincing. Had you invested that monthly $250 overpayment into a stock mutual fund earning 10% annually, it would have grown to roughly $3,141 for the 12 months that ended with January. That's a tidy $141 return.

By adjusting your withholding, you can avoid locking your money in a no-interest holding cell. Ask your employer for a fresh W-4 form, and review your allowances. Grab your most recent pay stub and last year's income tax return, and use the calculator at paycheckcity.com to guide your adjustments. To avoid underpayment penalties, shoot for the number of allowances that satisfies 100% to 110% of the prior year's tax payment (not counting your refund). Don't worry about nailing your withholding perfectly. Put a reminder in your date book in June, when you'll have a better handle on how your annual wages and withholdings will shake out.

If the forced-savings aspect of getting a refund appeals to you, keep reading to see why this strategy falls apart once the refund check arrives.

The problem with "found money"
Our best-laid plans (pay off debt, put it in savings, donate to Bono's causes) are easily sidelined once the check is in hand. Don't beat yourself up for not acting like the responsible adult you planned to be. It's natural. Behavioral economists -- think "money shrink" with an MBA -- say that people treat windfalls less responsibly than they do earned money. Though technically, a tax refund is not a windfall (you did earn the money), just try telling that to your brain.

To overcome this psychological hiccup, turn "found money" into "earned money" by putting it to work right away, with funds that you've already earmarked for a higher (non-shopping mall) purpose. Investing that money automatically can help you avoid spending it on things you don't really need.

For more tips on saving taxes, learn about:


Read/Post Comments (6) | Recommend This Article (21)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 20, 2009, at 9:56 AM, brucecanny wrote:

    If investing the amount above your tax liability is a good idea, then why isn't investing as much or your liability as you can a good idea [given a diligent investment into a savings vehicle]. To extend the example you have given, if my liability was $3000, and I did not withhold this, but instead paid it on Apr 15th, I would be ahead, according to your calculations, at least $7.50 but as much or more as $141. To put the money to even more good use, you could reduce your credit card liabilities providing an effective return of even greater (my CC interest rate is 11.24 percent). Obviously this advice is only good if you are diligent, but I have found nothing on the internet that supports this idea. Your thoughts?

  • Report this Comment On April 20, 2009, at 10:05 AM, outoffocus wrote:

    Obviously this advice is only good if you are diligent, but I have found nothing on the internet that supports this idea. Your thoughts?

    Thats because if you grossly underpay your taxes you will be subject to interest and penalties that you wouldn't have had if you broke even on your taxes. Also if you refuse to pay your taxes then earn money on the money that you didnt use to pay your taxes, you would subject to additional income taxes (interest and penalties) on the money you earned on that money. In summary, its better to just break even at tax time.

  • Report this Comment On April 20, 2009, at 11:15 AM, brucecanny wrote:

    Thanks outoffocus. I just talked to my tax person and you are right, if you owe more than $1000, then there is a penalty. Since we are talking about less than $1000, the cost/benefit analysis doesn't bear out. I therefore agree with your summary. Thanks again.

  • Report this Comment On June 10, 2009, at 8:03 AM, wit07 wrote:

    First, I'm a novice, but I'm extremely grateful for "fools.com". Ok...HELP! We get a "nice refund" ($10k Fed- $2k - State) but I'd rather have it in the paycheck. We can't find any other deductions and the IRS (website and phone center) say we're doing it right (oh brother). Do I/we need to go to tax accountant or a Financial Planner (CFP)? I've searched the web and either can't get an answer to my questions or I don't understand the language.

  • Report this Comment On August 03, 2010, at 5:40 AM, Jehnavi wrote:

    Be the most obvious one is to reduce your tax withholding by filing a new W-4 with your employer and claim more allowances in origin. If you find it difficult to save money once you have in your hands and you are using the denial of their taxes as a form of forced savings, why not have money automatically deducted from your paycheck and deposited in a savings account each pay period.

    http://www.financeandmarkets.net/how-to-check-tax-refund-sta...

  • Report this Comment On December 04, 2013, at 1:25 PM, alawrence37 wrote:

    Has anybody heard of www.1040Return.com? A friend of mine recommended it but didn't tell me much about it and now I can't seem to find any information anywhere! Any tips would be greatly appreciated.

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