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.
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.
- 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.
- 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.
- Keep abreast of new tax saving initiatives, such as energy saving tax deductions.
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.