Between digging up paperwork and receipts, crunching numbers, and filling out lines one through 37 on form 1040, filing your tax return can be downright exhausting. On top of that, there's the looming possibility of owing money to the government.
On the other hand, tax time may be a season to celebrate if you're among the many Americans who end up getting a refund. In 2014, the IRS issued almost 95 million refunds to the collective tune of $255 billion. In fact, each year, nearly eight out of every 10 filers are eligible for a federal tax refund, and last year the average individual refund totaled roughly $3,000.
Who wouldn't want a $3,000 refund check courtesy of our friends at the IRS? After all, that's extra money coming your way, right?
The biggest misconception about tax refunds is that they're simply free money. In reality, that's your cash -- the cash you earned and then handed over to the government so it could earn interest for Uncle Sam. Think of all the things you could've done with that money over the course of a year if it had gone to your paycheck instead. You could've invested it, avoided racking up credit card debt, or used it to pay down existing debt. Instead, you lent it to the government interest-free, which is not something to celebrate.
Don't let fear hold you back
The reason some people get refunds has to do with the fear of owing money. If you're living on a tight budget and don't have much in the way of savings, the idea of having to pay the government even a small amount of money come tax time might prompt you to err on the side of caution and overpay your taxes throughout the year.
But here's how that fear might be hurting your finances. Say you start the year with a $3,000 balance on your credit card at a 14% interest rate, and you repay that loan over the course of 12 months. At that point, you'll have paid a good $250 in interest as a result of not having the cash available to pay down that balance sooner. On the other hand, by paying a few hundred dollars more each month, you could knock out that debt before accruing those hefty interest charges. Imagine that instead of paying off that balance over 12 months, you managed to polish it off in six because you had the extra money in your paychecks. At that rate, you would've cut your interest charges in half.
Now let's take things a step further. Imagine you got a $2,400 refund, which could have been an extra $200 in pay each month. If you invested that money at a 6% return -- well below the stock market average -- you would earn an extra $80 in just a year's time. Compare that to a gain of just $13 in a savings account that pays 1% interest.
Because long-term investing is the best way to grow your wealth, let's take this another step further and consider the long-term value of that $2,400 investment. If that money continued to grow at a conservative 6% per year for 25 years, you'd end up with $10,000. Now imagine how much richer you could be if you invested that amount each and every year. In 25 years, you'd have another $150,000 to your name.
Don't let your fear of owing money at tax time stop you from getting what's rightfully yours all along.
Here's another issue with tax refunds: When you get one, you may be tempted to spend it rather than save it. If you're handed a $3,000 check, your first thought might be: "Vacation time -- woo hoo!" But in reality, had you been getting that money in your paycheck all along, you could've found a more responsible use for it -- namely, setting it up to filter automatically into your saving or investing account. In a recent survey by GOBankingRates, participants were asked how they plan to spend their tax refunds, and while 25% anticipate putting that money into a savings account, 13% intend to use it for a vacation or shopping spree. And while some will argue that having people spend their tax refunds is good for the economy, on an individual level, it's not ideal -- especially for those who should be using that money to pad their savings or pay down debt.
While many of us are inclined to believe that getting a refund at tax time is far better than owing money, in reality, owing a small amount isn't necessarily such a bad thing. If anything, it means that you, not the government, got to benefit from an interest-free loan, which is actually a pretty sweet deal when you think about it.