Tax Refunds – Are They Worthwhile or a Free Loan to the IRS?

Many believe that income tax refunds are not beneficial to anyone but the government. By allowing more money than necessary to be deducted from your paycheck in taxes each week, these investors state that you are essentially giving the government (via the IRS) an interest free loan.

Today, we will discuss tax refunds, are they worthwhile? There are both pros and cons to receiving a sizable amount back in the form of a tax refund.  Let’s present the facts, while you decide what is best for your bottom line.

You should maintain an active role in determining what your deduction needs are each year. Completing a new W4 with your payroll processing department may be needed. To review what your tax deduction needs are, use the official IRS withholding calculator. Have your current pay stub and your most recent tax return that was filed handy when you utilize this calculator.

Estimating these figures is possible, but your calculation will only be as accurate as the information that you provide. Many people do not understand that they are able to change their tax withholdings, and do not know how to properly fill out a W4.

Withholdings that receive the highest amount of taxes being deducted from each paycheck is single with zero exemptions, this will get you the largest amount of money back at income tax time. If you are married, you may also choose to withhold at the higher single rate with zero exemptions. You can also choose to have no taxes withheld by selecting all exemptions on your W4 form.

Keep in mind, you will be required to pay your taxes due at income tax time when you file a tax exempt W4 form. Many people are unable to feasibly pay the entire amount due, as they live paycheck to paycheck, so tax exempt certainly isn’t an option for most. Of course, the government is likely to grant a payment plan for the tax amount due, but there will be penalties and fees added to the amount due for failure to pay entire amount due by April 18th.

The Pros of Receiving a Tax Refund

Because so many families live paycheck to paycheck, they like to “bank” a little money at tax return time. They use this money to make large purchases, such as appliances, that they normally would be unable to make throughout the year. Many don’t mind that they are giving a free money loan to the government, since the interest rates on savings and money market accounts are so minimal.

This large chunk of money is often used to catch up on bills that you have fallen behind on because of the holidays. Maybe you fell into the category of paying for Christmas with credit cards, or needed some hefty car repair. That tax time relief is a welcome windfall. It is also nice not to worry about how you will pay for your heat or electric bill.

Others utilize their chunk of change to take a small weekend trip or plan a family vacation. These same people would face financial burden if they were faced with a large tax due bill, so they leave their with-holdings alone. Many people do not want to face fear at tax time, they prefer to feel exhilarated after hearing that they are receiving a large refund.

The Cons of Receiving a Tax Refund

Many people in their forties will not have enough money saved for their retirement. This is probably the largest con of receiving a tax refund. Many investors believe that it is necessary to reduce your lump sump received as a tax refund, and use it for investment purposes instead. Making regular small purchases throughout the year for stocks, bonds, and 401K are very beneficial, as the money invested builds slowly over time. Why not receive money from an interest bearing account, rather than give it to the government interest free?

Further given ongoing delays in IRS refund processing schedules, you could be waiting for months or years to get your refunds if there are issues found with your tax filing.

The Cost of your Refund

Let’s assume that you are receiving a $2000 income tax refund this year. Let’s take a look at what you would have accumulated in a savings account earning a 1% APY, with interest being accumulated monthly:

Month

Monthly Deposit

Interest Earned

January

$167.00

$1.67

February

$167.00

$3.25

March

$167.00

$5.03

April

$167.00

$6.73

May

$167.00

$8.42

June

$167.00

$10.10

July

$167.00

$11.79

August

$167.00

$13.48

September

$167.00

$15.16

October

$167.00

$16.85

November

$167.00

$18.54

December

$167.00

$20.23

Would you miss $167 a month? Essentially, you wouldn’t have to miss it, because if you changed your with-holdings on your W4, you would get an increase in your paycheck. Having optimal with-holdings should create a minimal tax return. That is why you get that informational letter from the IRS if you get a large return, reminding you to check your with-holdings.

Granted, the interest earned in 12 months is minimal at $20.23, but once you leave that money in the savings account and let the interest start compounding, you will see the savings grow exponentially. At the end of five years, with your continued monthly deposit, you account will have earned $192.51 in interest. It will grow even more if the interest rates goes above 1% APY.

Truly, the choice is yours, what is your preference? Continue getting that one lump sum at income tax, or stash small amounts away each month to start earning some money? Remember, the majority of people in the forty year old bracket will not have enough money saved for retirement. How long do you want to work for? Do you fall short in your retirement savings? Make small changes today for big returns later!

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2 thoughts on “Tax Refunds – Are They Worthwhile or a Free Loan to the IRS?”

  1. Thanks, this post was written by a guest contributor. I have updated APY (you are right – should be 1%).

    Reply
    • The numbers still are not correct. One percent of $167 is $1.67, but at a 1% APY compounded monthly, it will take a year to earn, not a month. If I deposit $167 on January 1st into an account earning 1% APY, at the end of January I would be credited with a month’s worth of interest (one-twelfth of 1% of $167), or about 14 cents. Depositing $167 per month for a year would only earn about $11 in interest, not $20.23 as shown in the example.

      Reply

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