By now, tax season is in full swing. Many folks have already filed their returns and received refunds, and many more will do so in the coming weeks. (If you have not yet started on your taxes, contact us for help!) Approximately three-fourths of all individual federal income tax returns result in refunds. Sure, having that money is great, but is it really the best outcome?
I still recall when, at a St. Patrick’s Day party sometime in my early twenties, someone was complaining about some expensive car repairs. Another person chimed in gleefully: “That is what tax refunds are for!” Unfortunately, many people fall into the trap of relying on their tax refunds to cover unexpected expenses.
Relying on your tax refund to cover an unexpected expense, or otherwise plugging leaks in your family finances that accumulate over the course of the year, is dangerous. (February is a busy month for bankruptcy lawyers because credit card bills from December holiday shopping typically arrive in January.) Even if you do not fall into that category, receiving a large tax refund is usually less than ideal.
Why is relying on your tax refund dangerous?
Relying on an expected tax refund is dangerous for several reasons. First and foremost, your tax refund might be lower than last year, or you might even owe money. This can happen as a result of changes in your financial situation, a surprise mutual fund dividend at the end of the year, or last-minute changes in the law. Many of these changes are small and go unnoticed, but they can impact your bottom-line results when you consider them together. Other times the changes might be more significant, but you were caught unaware. A great example is the child tax credit: the higher amounts that taxpayers received for 2021 were for that year only.
Second, if you have certain kinds of debt – past due child support or taxes owing for another year, for instance – your tax refund could be subject to offset.
Third, even if your tax refund is higher than expected, you run the risk of spreading it too thin. At different times, you might think you will finally replace the dishwasher, repair the car, or pay off your dental bill when the tax refund arrives. Maybe the refund is enough to cover the dishwasher, but it might not cover the car and dentist as well. As we explained last month, the way to avoid this trap is to expect the unexpected by harnessing the power of high-yield savings accounts.
Finally, the IRS might take a long time to process your return for any number of reasons, through no fault of your own. IRS delays are well-documented. That refund may not arrive when you expect or need it.
Can a refund be bad?
Perhaps you do not count on receiving a refund but you still look forward to a mini-windfall each year. You might be the type of person that sees a tax refund as a savings tool. I am certainly a fan of savings tools, but there are better options.
The primary reason that a large tax refund can be bad is that you are effectively loaning money to the government interest-free all year rather than putting that money to work for you. That extra $5,000 in a high-yield savings account earning 3% interest will generate enough income for a fancy birthday or anniversary celebration, or perhaps allow you to upgrade to the Diamond Club when Mookie Betts brings the Dodgers to town.
When all is said and done, though, you still pay the same amount of tax whether you have a large refund, a small refund, or even owe money. It is just a matter of timing. Make the timing work for you.
If you want to take it up a notch, you might even budget for a balance due as one of your savings goals! Owing the IRS $1,500 while having $5,000 set aside for taxes has the same net effect as receiving a $3,500 refund, except that you were earning interest on that $5,000 all year.
A word of caution: because the United States employs a pay-as-you-go tax system, you will incur a penalty if you owe too much at the end of the year. But if you pay enough during the year to avoid the underpayment penalty, and pay any balance due by the deadline, you will not incur any extra costs. We can help you plan accordingly.
Can a refund be good?
Of course, maybe receiving your refund in a lump sum at the end of the year rather than having more money available each month throughout the year is how the timing works for you.
If you are generally risk-averse, you will typically err on the side of caution by paying more towards your taxes throughout the year. If the thought of owing money to the IRS scares you and the possibility of having to write a check at the end of the year keeps you up at night, then by all means get some sleep! If you know that the additional money each month will not realize its full potential, but the year-end lump sum will have a meaningful impact, then perhaps the large-refund route is the right choice provided you do not rely on that expected refund (in whole or part).
Tax planning gets more complicated as your finances grow in complexity, but it is a fun puzzle to tackle. The path I recommend – and follow myself – is trying to come as close to breaking even as possible. My personal best is a net $44 refund between my federal and state returns. I still set aside extra money throughout the year, though, so I am prepared for contingencies and earn interest instead of loaning that money to the government interest-free.
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