That Tax Refund Is a Rip-Off

It’s hard to beat the thrill of a windfall. In a typical year, as many as 75% of us will feel that rush, courtesy of the IRS. Recently, average refunds have come in just shy of $3,000.

Not that we have anything against checks made out in our name, but there are a few reasons to take a dim view of this annual financial rite of passage.

The worst investment ever
First, that check represents an interest-free loan to Uncle Sam — $250 a month of your money that isn’t earning squat in interest. A lot of taxpayers would rather over-withhold from their paychecks than owe the IRS come April. But consider the cost of doing so over the course of one year.

If the IRS were paying out measly checking-account rates of around 0.5%, you’d be able to pick up the tab for a few espressos — or $7.50. Even if you could earn 4% from a high-yield savings account, it’d amount to just $60.

Nonplussed? We hear you. But we’re committed to turning non-investors into shareholders, and we think the following results are pretty convincing. Had you invested that monthly $250 overpayment into a stock mutual fund earning 10% annually, it would have grown to roughly $3,141 for the 12 months that ended with January. That’s a tidy $141 return.

By adjusting your withholding, you can avoid locking your money in a no-interest holding cell. Ask your employer for a fresh W-4 form, and review your allowances. Grab your most recent pay stub and last year’s income tax return, and use the calculator at paycheckcity.com to guide your adjustments. To avoid underpayment penalties, shoot for the number of allowances that satisfies 100% to 110% of the prior year’s tax payment (not counting your refund). Don’t worry about nailing your withholding perfectly. Put a reminder in your date book in June, when you’ll have a better handle on how your annual wages and withholdings will shake out.

If the forced-savings aspect of getting a refund appeals to you, keep reading to see why this strategy falls apart once the refund check arrives.

The problem with “found money”
Our best-laid plans (pay off debt, put it in savings, donate to Bono’s causes) are easily sidelined once the check is in hand. Don’t beat yourself up for not acting like the responsible adult you planned to be. It’s natural. Behavioral economists — think “money shrink” with an MBA — say that people treat windfalls less responsibly than they do earned money. Though technically, a tax refund is not a windfall (you did earn the money), just try telling that to your brain.

To overcome this psychological hiccup, turn “found money” into “earned money” by putting it to work right away, with funds that you’ve already earmarked for a higher (non-shopping mall) purpose. Investing that money automatically can help you avoid spending it on things you don’t really need.