April 15th (or thereabouts, if it falls on a weekend) is Tax Day in the United States. Our friends in Canada have until April 30th, unless you’re self-employed, in which case you have until Monday June 17th.
Personally, I filed my tax return back in February and received my tax return 13 days later in early March. But while I was waiting on my final tax forms to arrive, I threw a post up on Twitter asking how the community feels about the whole “tax refund vs. no tax refund” argument. As you can imagine, the results were mixed:
Out of 134 votes, 29% were on “Team Tax Refund.” These folks over-contribute tax money throughout the year. In doing this, they get a check or direct deposit from the government in one lump sum. For all the talk that the Personal Finance community does about “what to do with a lump sum” like a bonus or an inheritance, it surprises me to see that a tax return lump sum is seen as a missed opportunity.
The biggest vote-getter was “No interest-free loan” to the government. These 37% of voters have underpaid their taxes throughout the year, but not by an amount that would cause penalties and interest to be charged against them. One way to do this is by increasing your withholdings on your W-4 with your employer. The result of this is more money in your paychecks, but with a balance due to the federal government by tax filing day. You can file an extension on filing your paperwork, but the taxes owed are due that day.
The option that surprised me the most was “Somewhere in-between‽” 34% of voters fell somewhere between these two extremes. Perhaps they are unaware of what their tax liability will be throughout the year. Maybe they don’t have an inclination for or against giving the government some extra money to hold onto for a while for them. Whatever the reason, getting a refund or owing a little bit is not something that concerns them too much.
Comparing the two sides
Of course I want to write a bit about the two extremes. Most of what I’ve read on personal finance blogs and heard on podcasts is against loaning money to the government interest-free. The implication is that the taxpayer is losing out on the ability to do something with that money that would otherwise be overpaid to the government on each paycheck. Since we don’t advocate investing money that will be needed in the next 12 months (gambling!) the best option would be a high-yield savings account or short-term CD. Over the past decade, those haven’t been paying much, so I don’t personally see this as some huge win. Furthermore, these amounts accrue in small chunks over the course of 52 weeks. For the sake of easy math, let’s say we’re talking about a potential $1,040 return, or $20 a week. With $20 a week extra in your paycheck, it will probably not be noticeable, or only barely so. It is harder to make conscious decisions every day over the course of a year with that little extra money than it is to save a windfall of $1,040.
On the other hand, windfalls are often seen as an opportunity to splurge. $1,040 isn’t a life-changing amount of money, but it could buy a lot of clothes/shoes, a vacation, or a nice TV. Maybe the refund is split into a ratio of splurge/save, or just spent to pay down debt. Psychologically, getting that windfall and focusing it to a specific purpose can be a huge win.
Ways to change the outcome of your tax bill
As most of you reading this will know, there are ways to lower the amount of taxes you owe in the current tax year. These come in the form of a retirement account like a 401(k), 403(b), 457(b), Traditional IRA, a pre-tax health plan such as an FSA or HSA, college savings plans such as a 529 or Coverdell ESA, or a few more obscure options. By saving money in these accounts, you shelter them from exposure to the tax man in the year of the contribution. In the case of the retirement accounts, the money inside them grows tax-free and is only taxed upon withdrawal.
If your income is $60,000 and you contribute $18,000 to a 401(k), suddenly your taxable income for that year is reduced to $42,000. Given the higher standard deduction now available, the Adjusted Gross Income for this very simplified example is only $30,000, squarely in the 12% marginal tax bracket. Without the 401(k) contributions, the $48,000 AGI (60k – 12k) would be in the 22% marginal tax bracket.
In much the same way that the “debt snowball” method isn’t the mathematically superior solution, neither is getting a tax refund. Debtors could save themselves a lot more money paying off high-interest loans, and taxpayers could earn more money by saving diligently throughout the year for their tax bill come April of the following year. But we don’t always choose the mathematically sound route, because emotions play a big role in our money stories. We don’t notice that extra $20 a week coming off our mortgage principal, but we really see it and feel it when we see a $1,000 chunk come off.
Do what makes sense to you. If you can stay on task and keep the money saved for the tax bill that will result, go ahead and increase your exemptions on your W-4. If you’d rather overpay slightly and wind up with an annual windfall each spring, go ahead and keep your W-4 as-is, or even consider increasing your withholding slightly to increase the size of that windfall. Or better yet, increase your retirement contributions to a 401(k) or Traditional IRA to reduce your taxes owed and keep more of your money for Future You.
Where do you fall on this argument? Is it silly to even have an argument about this topic? Am I wrong to think it’s like Debt Snowball vs. Debt Avalanche in that there’s clearly a mathematically superior answer, yet lots of people believe in the less-optimal answer?