Getting a big refund? Ask yourself why you’re lending the government interest free money.

dont_throw_money_awaySoon enough, Americans will be filling out their tax forms in anticipation of a large income tax refund. But should they be so excited? The fact is, if you’re receiving a large income tax refund, or any refund at all, you have lost money. How could this be? What can you do to stop this from happening again and how can you end next year with more money than you would if you continued receiving large refunds like now?

Many people treat their income taxes like a savings account, in which they pile up money they don’t touch throughout the year by having more money taken out of their pay for taxes than they are going to owe. The major problem with this method of savings is that you’re giving the government your money to hold and earn interest on. Instead, if you were to correctly estimate your withholding’s, claim the proper amount of deductions, you could earn interest yourself on that money, instead of giving the government your money to hold interest free.

Let’s show you an hypothetical example of what I’m talking about, in case you’re more of a visual person. Let’s use an example of two brothers, Fred who thinks it’s cool to get a large refund, and the other brother Mike, who wants to make every dime possible he can.

Fred has 3 kids and wife, although, on his taxes he claims only 1 person. Fred makes $50,000 per year. This results in his work taking out more taxes than he owes to the tune of $500 per month, or $6,000 per year. Fred files his taxes after the end of the year, and no surprise, he get’s back his $6,000 that he overpaid.

Mike, the self proclaimed frugal and savvy type, also has 3 kids of his own and a wife and he makes the same $50,000 per year as his brother. But instead, Mike claims 5 people on his taxes and so his payroll department takes out nothing over and above what Mike owes to the government per month. Now Mike takes the $500 and has it automatically deposited into a savings account at the end of the month, which earns %4 interest, compounded monthly. At the end of the year, Mike would have $6,132. That’s $132 more than his brother Fred for nothing. That’s $132 that the government would have, instead of Fred.

Some people will say that the main reason they do this and will continue to accumulate massive refunds in spite of knowing that they are actually losing money is because they are unable to effectively save that money, that they know if they have that extra money each month they won’t save it. With automatic withdrawals into savings accounts you can eliminate this temptation. Moreover, if you’re thinking and or fearing that you may touch those savings dollars, purchase CD’s with 6 month or annual maturities (many banks allow the ability to automatically renew too).

It’s never too late to make the change. Walk down to your payroll department now, and correct your withdrawals. The payroll department should be able to tell you what the difference is in your take home pay, and change your direct deposit to accommodate that additional portion of your pay to be deposited into a savings account. From there if you believe you may still be tempted to spend that money, talk to your bank about automating the purchases of CD’s (these often have better interest rate than your typical savings account). You have the ability to save more money now, don’t delay get started now!

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8 Comment

  1. Personal Finance Buzz…

    Your story was featured in Personal Finance Buzz! Please visit and promote your article….

  2. Social comments and analytics for this post…

    This post was mentioned on Reddit by CANONinDEVIN:

  3. This is a great article. I always advise people to represent their tax situation properly when completing their W-4’s for Payroll. However, I hear the same arguments that you mentioned – they’re not disciplined enough to save it, so they’ll just lend it to the government and get a large refund.

    Also, some people just love the feeling of “new found wealth” that comes with a large tax return.

    Hopefully this article will help more people to see the folly in this type of thinking.

  4. FinanceDad says:

    Thanks for your comment!

  5. >savings account at the end of the month, which >earns %4 interest, compounded monthly

    That exists?

  6. FinanceDad says:

    As mentioned in the reddit thread there are multiple places that will pay you 4% interest or more.

    http://www.highyieldcheckingdeals.com/

    Check your local credit union too.

    Granted, some of these places require deposits of $500 or more. Moreover, the point was to illustrate the potential. Using interest rates right now isn’t indicative of historical rates or future rates.

    Thanks for your question!

  7. jwiz says:

    How do you get $631 by earning 4% interest for a year?

    Even if you had all $6000 in at the start of the year (rather than $500, $1000, $1500, etc.), you’d still get:

    6000 * (1+(.04/12))^12 = $6244.20

    Or did I flub some math somewhere? I just don’t see how you can get more than 10% yield (631/6000) from 4% interest rate, especially since you are adding the $500 each month.

  8. FinanceDad says:

    No, you’re right. The problem I had was starting with $500… that inflated the number accordingly. I will correct immediately, thanks for pointing that out.

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