16 Apr 2021 Why I Prefer a Big Tax Refund

“It’s income tax time again, Americans: time to gather up those receipts, get out those tax forms, sharpen up that pencil, and stab yourself in the aorta.”

– Dave Barry

There’s a popular line of thinking that goes something like this: getting a large tax refund is bad because it means you lent money to the federal government for a few months and received nothing in return. The IRS doesn’t pay interest when they collect more than you owe so there’s an opportunity cost to overpaying.

Not only do I disagree with this, I actually enjoy receiving a good-sized refund and believe it provides me and my family with a financial benefit.

Here are three reasons we find a large tax refund beneficial.

It Caps Our lifestyle

One of the reasons 401(k) contributions are so effective is we never handle the money; it’s taken out of our paycheck before we get the chance to spend it. Extra tax withholding is similar and creates, as Jared discussed a few months ago, a bit of an “artificial constraint” on our lifestyle.

A real fear of mine is that as our household income grows, our lifestyle will grow right along with it. We refer to this as “lifestyle creep,” something as common as it is insidious. If spending increases at the same pace as pay raises, financial freedom gets more difficult to reach. This is a way we put a cap on our lifestyle.

It Means Less Opportunity for Mistakes/Waste

Intuitively, I understand the argument against providing the IRS with an interest-free loan. But, that argument pre-supposes we’ll always make great financial decisions. As much as I’d like to pretend there’s not a wasted dollar in the Smith household, that’s just not the case.

Let’s say our federal refund for 2020 was $6,000. We could have had $500 a month in additional take-home pay, but that would require discipline in setting it aside and not touching it. Could we do it? Probably. But it can be easy to justify an additional expense every time there’s a deposit. By receiving it all at once, not only have we had time to think through what our priorities are, but we only have to make one decision about how to divvy it up.

(I also understand how you might make the exact opposite case: A large refund could make us feel flush and trigger a foolish purchase. Which is why all financial decisions and strategies need to be made with an understanding of how you’ll operate best with your money. To quote Tim Maurer, “Personal finance is more personal than it is finance.” This is what works for us.)

We Can Allocate the Refund to Fun/Meaningful/Essential Stuff

When our refund comes in, we have the opportunity to allocate it in ways that are meaningful and important to us. The last few years we’ve prioritized Jack and Gwen’s school tuition, and, since our medical expenses tend to run higher than average, fully funding our Health Savings Account. Knowing these expenses, not small, are fully/partially funded for the coming year gives our budget flexibility and provides us with a sense of peace.

But we aren’t practical with all of it. We set some aside for vacations and other discretionary spending that we put off throughout the previous year. An ancillary benefit of waiting until you receive a refund to make a discretionary purchase is that you have a lot of time to think and make sure it’s of real importance.

It’s crucial to point out that a refund isn’t something we rely on. If, for some reason, we misjudge and don’t receive one, our budget won’t fall apart.

Ultimately, whether you receive a large refund, small refund, or try and perfectly match your withholding to your liability doesn’t matter too much. What does matters is creating a system that works for you and allows you to make responsible financial decisions. Any approach requires intentionality and coordinating with your tax professional to line your withholding up with your preference.

So, as you are getting your tax returns back this year, be mindful about your refund (or liability). Is it working? Does it feel right? Do you have the discipline to save with each paycheck or would a lump-sum make it easier?

And if you were caught off guard and owe the IRS, ask your financial advisor and CPA what you can to make sure it doesn’t happen again next year.

Questions? Schedule a call with us here.