If you follow any personal finance blogs, you will probably notice that a lot of them tout the advice to “stop giving the government an interest free loan!” This advice is based on the fact that the average income tax refund is around $3,000. When we overpay our taxes, we let the government keep that loan, but they never pay us interest. Sounds like a bad deal doesn’t it? It might not be so bad.
More in the Paycheck
The idea is to reduce your withholdings in order to keep more money in each paycheck. Let’s suppose you were to accurately estimate your taxes so that when you filed your return, your refund was $0. Based on the average refund amount, you will have around $115 extra dollars in your paycheck every two weeks.
Now suppose that you did have the discipline to actually save that $115. You put it into a savings account and let it grow earning you interest all year long. At the end of the year you would have less than $3,030. Based on current interest rates of around 1%, your hard work and discipline would net you less than $30.
Of course, most people won’t have the discipline to save the $115 from each paycheck.
A Bigger Tax Refund
On the other hand, let’s suppose you didn’t worry about estimating your taxes so precisely. After you file your taxes you get a refund of around $3,000. You rejoice that you have some money back, and you dump $2,700 into a savings account and then splurge the other $300 on buying something nice for yourself.
At the end of the year you have $2,700 in your savings.
Which Would You Rather Have?
Most people, if they have the extra $115 in their paycheck will spend that $115. They will see the extra money and think they can stay for that extra drink at the bar. They will go out to eat one more time this month. They will buy a new pair of shoes or a new coat. Now there is nothing wrong with those things, but if your “refund” is being spent on them, it defeats the purpose of taking a bigger paycheck in order to save more.
The reason is that psychologically we see the money coming in differently. When it comes in slowly, as part of our paycheck, we think of it as money that we earned and we can splurge on whatever we want. We also don’t see the harm in small purchases of $20 or $25. However, when it comes in as a big chunk, it’s seen as a windfall. Even though $2000 all at once is the same as one hundred $20 purchases, it feels different. We are more inclined to save large chunks of money than to spend them.
So if you are trying to minimize the size of your tax refund by taking more in every paycheck, you may be setting yourself up to spend more money than if you were to let the government hang on to your money “interest free.”
Hire an Accountant for Maximum Refund
Practical Taxes can help you get the most out of your taxes. We know tax laws. By hiring him to do your taxes you free up your time, make sure they are done right, and most likely your refund will be larger than if you try to do your taxes on your own (even after paying the modest accountant bill). Contact Practical Taxes today to learn more about what we can do for you.