Over the holidays, my husband’s family spent quite a bit of time with us. His brother mentioned that he is expecting a nice, large tax return. “I use it as a sort of savings account,” he said. “That way, I know I’m getting something back.”
Before I could help myself, I blurted out: “But why? You’re giving a free loan to the government. That’s money that could be working for you!”
My brother in law’s remark isn’t really very rare, though. Many people view their tax returns as a sort of savings plan. They don’t claim all of their exemptions when they fill out their W-2 forms, or they have extra money withheld from their paychecks for taxes. That way, when the end of the year comes and it’s time to prepare the tax return, a tax refund is offered. In fact, the IRS reports that the average tax refund is more than $2,000. While that is a nice chunk of change, getting it back from the government isn’t exactly the most efficient way to build wealth.
Here are two reasons that you should stop using your tax refund as a savings account:
1. You aren’t earning any interest
Even with a traditional savings account, you are earning interest. It may be less than 1% annual yield, but it’s still a yield. Other savings vehicles, such as high yield savings accounts, CDs and even rewards checking accounts, offer better returns. When you have extra money withheld from your paycheck to work as a “savings plan”, you are really just providing an interest-free loan to the government. That’s not free money you’re getting — it’s your money being returned to you. But if you had lent it out using a person to person lending program, or if you had lent it to the government through bonds, you would have earned a return. Instead, you are inefficiently tying up money that could be going to work on your behalf.
2. You could spend the money on something else
It may seem strange to think of it, but you could be using the money you have sent to the government for things of more immediate benefit to you. If you get a $1,200 tax return (which is lower than the average), that’s $100 a month you could be using on something else, rather than tying it up for no good reason. Many people use their tax returns to pay down debt. They “save up” that money, and then pay down their debt with it. However, during the whole year that they are saving up to make a bigger payment, they are paying a high rate of interest — probably in excess of 15%. If you have debt, and use that $100 a month to pay down the principal, you will reduce the amount you pay in interest over the year. However, if you save up to make a bigger payment, that interest is not saved. You could also be using that extra money to pad your retirement account or boost your emergency savings. And, you would be earning interest on those true savings plans.
In the end, it is a good idea to try and get your tax return as close to $0 as possible, and put your money to good use. If you are really daring, you could even arrange it so you owe money. That means that the government has been giving an interest free loan to you! Just be careful; there is a penalty if you owe more than $1,000.
Editor’s Note: I personally have a slightly different view on this. I totally agree that having too much withheld and paying interest on your debt is not a good idea, but letting Uncle Sam keep your money instead of having it in a savings account could work well if it makes you feel more of a need to save throughout the year.
Additionally, I would consider how you react when you receive a big tax refund every year. Do you put every cent into savings, or do you always use some of it for something you really wanted? All these factors will affect what’s right for you. That’s why personal finance is personal, and that’s why it’s so interesting.
The key is to thoroughly think about the choices, and make an effort to decide (instead of making the default choice decide for you).