Most Americans hate filing taxes, and would rather receive a refund than pay a large amount to the government. Thus is the debate between having to pay a surprising lump sum versus receiving a refund. In essence, getting a refund means you have lent the government your money for the duration of a year, without requiring the government to pay any interest on the loan - a beneficial situation for the government and a poor one for your money. (The short-term loans found in Refund Anticipation Loans: Ripoff Or Royal Screwjob? can provide much-needed cash, but the instant payout comes at a cost.)

A Dollar Today Vs. A Dollar Tomorrow
The principle of time value of money essentially states that the value of a dollar today is worth more than a dollar in the future. The main reason for this is due to inflation of prices, as a dollar in the future can purchase less than a dollar today can. In normal environments, inflation is positive. It is a rare occurrence when there is negative inflation or deflation. However, the time value of money can be equal today and in one year, if there is interest paid on that money.

For example, a $100 investment earning 3% interest will be worth $103 dollars after one year. Therefore, $100 paid now or $103 paid in one year from now, will have the same value. When applying this principle to taxes, letting the government borrow your tax dollars at a nominal interest rate will yield you the same value of money in the future as it does today. (The foreign tax credit provides a break on investment income made and taxed in a foreign country. For more information, read Get A Tax Credit For Your Foreign Investments.)

But the government does not pay interest, so letting the government borrow your tax dollars interest-free for one year yields you a lower (or negative) return on your dollars. Essentially, letting the government hold your hard-earned cash for one year means that, when you get it back one year later, it has less worth; you can buy fewer goods in one year than you could have purchased today.

Opportunity Costs
The opportunity lost from loaning the government your money in the form of taxes can be significant, depending on the size of the loan (refund). Making investments, opening a savings account or keeping the money in an interest-bearing checking account should all provide some type of positive return that will be greater than just getting your money returned to you in the form of a refund from the government. Even buying a large-screen television, and having the use of that television for one year, yields a higher return to you. (If the IRS finds errors, it will cost you. Find out how to fix them - and prevent them in the first place, in Inaccurate Tax Return, Now What?)

The Psychology of Paying
Most people are poor budgeters, and do not forecast a large lump sum payment to the government at tax time. And many people think it just feels better to get a refund rather than have to pay a lump sum to the government. There is the psychological euphoria that comes with finding out you get a refund - as if you won the lottery or found money in an old pair of pants. Many people also think that getting a large refund is a way to force savings, something most Americans are not good at doing. However, realistically, most people take that refund and go shopping rather than put it into a savings account.
What To Do
There are options available to assist you in minimizing refunds and lowering taxes.

  1. The easiest way to minimize a refund or large tax bill is to change your withholding status on your W4. The government publishes documents to help guide you with the proper elections. IRS Publication 505 and 919 provide guidance for proper withholdings. Both are available at www.irs.gov.
  2. Lower taxable income by participating in an employer 401(k) program and flexible spending accounts. Flexible spending accounts for health care and dependent care are great ways to use tax free money to pay eligible bills.
  3. Keep abreast of new tax saving initiatives, such as energy saving tax deductions.

Conclusion
Don't get caught in the psychological trap of feeling good when you get a refund - you don't want to be the one who allows the government to pay you less money in the future than you would have had today. This is your money, and you should be the decision maker on how to utilize it.

Related Articles
  1. Taxes

    Free 2016 Tax Preparation! Top Online Services

    A place that fills out and files your taxes free of charge? It's no myth, as long as you have a simple return. Read on to find the top preparers.
  2. Taxes

    Why People Renounce Their U.S Citizenship

    This year, the highest number of Americans ever took the irrevocable step of giving up their citizenship. Here's why.
  3. Taxes

    Taxes: H&R Block Vs. TurboTax Vs. Jackson Hewitt

    There are more and more tax services to help ease the pain of filing income taxes. Here's our take on three of the biggest.
  4. Taxes

    Confused About Estimated Tax Deadlines for 2016?

    If you run a business or have investment income, pay attention to this year's estimated tax deadlines. Here are the details, and what's new for 2016.
  5. Retirement

    Retirement Plan Tax Prep Checklist

    Here's a list of items you need to have in order by tax time, including paying attention to those pesky required minimum distributions.
  6. Tax Strategy

    A Beginner’s Guide To Tax-Efficient Investing

    Tax-efficiency is a measure of how much of an investment’s return remains after taxes are paid.
  7. Retirement

    The High Net Worth Guide to Medicare

    In the years ahead, wealthy seniors will pick up an even bigger part of the Medicare tab. However, there are ways to minimize the bill.
  8. Philanthropy

    How Billionaires Around the Globe Give Back

    This list of foreign billionaire philanthropists is robust. Here's a list of rich entrepreneurs around the globe who have given back in really big ways.
  9. Retirement

    Your Retirement-Planning Team

    As you accumulate wealth, retirement planning can be too complex for just one person. The right team can help you avoid headaches and reach your goals.
  10. Investing Basics

    Know Your Stock Cost Basis

    A stock’s cost basis is its purchase price plus all reinvested dividends and commissions.
RELATED FAQS
  1. When should my tax refund arrive?

    More than 90% of income-tax refunds arrive in less than three weeks, according to the Internal Revenue Service (IRS). However, ... Read Full Answer >>
  2. How do I file taxes for income from foreign sources?

    If you are a U.S. citizen or resident alien, your income (except for amounts exempt under federal law), including that which ... Read Full Answer >>
  3. Are Flexible Spending Account (FSA) items tax deductible?

    Flexible Spending Accounts (FSAs) are employer-sponsored, tax-favored savings plans expressly for the future reimbursement ... Read Full Answer >>
  4. How Long Should I Keep My Tax Records?

    The Internal Revenue Service (IRS) has some hard and fast rules regarding how long taxpayers should keep their tax records. As ... Read Full Answer >>
  5. Do tax brackets include Social Security?

    A portion of your Social Security benefits may be subject to federal taxation using tax brackets. Your tax bracket is determined ... Read Full Answer >>
  6. Do 401k contributions reduce AGI and/or MAGI?

    Traditional 401(k) contributions effectively reduce both adjusted gross income (AGI) and modified adjusted gross income (MAGI). ... Read Full Answer >>
Trading Center