Do you want a tax refund?

The Myth of the Tax Refund

It’s that time of year again.  No not time for the ACC basketball tournament and March Madness, but that time of the year where everyone celebrates their tax refund.  It’s a time honored tradition where everyone is excited to get their money back from the Federal Government.  But should we celebrate it?  Let’s review the history of income tax withholdings first. 

History of Income Tax Withholdings

In 1943, Congress pushed through the Current Tax Payment Act which required taxpayers to stay current on their tax liability.  They accomplished this via a new withholding system applied to earned income (e.g., salary and wages). 

Prior to 1943, taxpayers didn’t have to pay throughout the year.  They simply had to pay “next year for taxes due this year.”  This made the US Treasury department a creditor to every single taxpayer in the country.  As the Federal government needed more revenue to fight World War II, it was necessary to expand the income tax base by taxing more citizens.  However, taxing more citizens meant that the quality of the debtors would decline unless a smoother way was made to collect taxes. 

It wasn’t just a deterioration of the income tax base that prompted Congress to pass the Current Tax Payment Act though.  The War was creating inflation.  And this meant that a dollar tomorrow was worth less to the Federal government than a dollar today.  It needed the revenue sooner and a withholding system was the perfect way to get it done.  Incidentally, it also made it easier for the Federal government to raise taxes in the future.  After all, a small increase in taxes owed every single pay period is not as tough to bear as a bigger check to cut at the end of the year. 

Congress had seen a successful withholding campaign implemented through the Bureau of Old-Age Benefits – which was one of three initial operating bureaus set up administer the Social Security Act.  So they passed a law that required citizens to pay income taxes on wages and salaries as the income is earned. 

Two Options with your withholdings

It is extremely unlikely that you will ever pay exactly what you owe in Federal income taxes - unless you owe nothing and you pay nothing.  Therefore, you really have two options: pay more than you owe throughout the year or pay less than you owe throughout the year.  If you pay more than you owe, then you get a refund at the end of the year.  If you pay less than you owe, then you write a check to cover the difference.  

So do you prefer to owe the government money or do you want to receive a refund?  

Lend Money to the Federal Government

Americans are known to spend.  It’s one thing that we do really well.  So the argument is that overpaying the Federal government is a method of creating savings.  The problem with this is that if Americans are truly spenders and not savers, most Americans will receive their tax refund and spend it.  So the question becomes do you prefer to spend your money now or in February, March or April when you receive your refund?  Or maybe more importantly, can you trick yourself into saving throughout the year.    

By overpaying income taxes, you need to realize that you are essentially giving the Federal government your money to spend as they will until you file your tax return.  At that time, they will send you back a check for what you owe – with no interest paid to you.  In essence, you have lent the government money through a no interest loan.  For all of those people complaining about not receiving interest on their checking account, beware as you are getting the same thing from the Federal government when you lend them money. 

Be Lent Money by the Federal Government

If you are a good saver then this is unquestionably the route for you.  If you can save money and be prepared to send a check to the Federal government in April then you have flipped the equation and received an interest free loan from the Federal government for the amount of taxes you owe them.  During times of higher interest rates, you could let that amount sit in a very safe checking account and earn you interest – with little to no risk.

You have to be careful though.  The Federal government (and state governments) recognizes that some individuals will try to minimize what they pay the government throughout the year so they require that you pay either 90% of current year taxes or 110% of your previous years tax liability.  If you don’t satisfy one of those two then you owe the Federal government an underpayment penalty. In other words, don’t stop paying them completely but do consider how

Conclusion

So it depends.  Are you a good saver?  If the answer is no, then you may want to change your habits and stop lending the Federal government money with no interest received.  If you are a good saver then stop lending money to the government and let it work for you.  Know your own limitations though.  Don't get caught thinking that you are a good saver when deep down you know that you aren't.  This could lead to further financial trouble, especially if you rely on a credit card to help you pay your tax bill come April.