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Tax refunds aren't evil

Conventional financial wisdom says it's better to adjust withholding than to get a big refund. Here are five reasons why a refund is good.

By MSN Money Partner Mar 28, 2012 6:55PM

This post is by Dave Carpenter of The Associated Press.

 

Getting a big tax refund is supposed to make you feel guilty.

 

Financial planners say it means you've had too much withheld from your paychecks.

 

You let the government keep your money and failed to collect interest for all those months. You also deprived yourself of the opportunity to earn an even greater return.

 

Technically, they're right.

 

In a perfect world, your withholding would be exact and you and Uncle Sam could just call it even. And you would put all the extra dollars in every paycheck to work instead of waiting for a fat check the following year.

 

But if you count on a refund, don't feel bad. It doesn't necessarily make you a lousy money manager, especially in these challenging, low-interest-rate times.

 

And you have lots of company.

 

Even with increasingly sophisticated tax software that makes it easier to calculate proper withholding, most people choose to come out way ahead at tax time. About 75% of individual taxpayers get a refund every year and the average amount is about $3,000. (Post continues after video.)

Through March 10, the Internal Revenue Service already had issued more than 59 million refunds worth $174 billion for the 2011 tax year, for an average of $2,946.

 

Mark Steber, chief tax officer for Jackson Hewitt Tax Services, still prepares returns for family members and finds they all love a big refund. He doesn't discourage them even though he could argue against over-withholding.

 

"You can say you need to be better organized, just like you need to get more exercise," Steber says. "But people need to find what works for them."

 

Besides, he says: "My wife thinks I'm smarter if I get us a large refund."

 

Here are five reasons why having more withheld than your expected tax bill can make sense:

 

Avoiding a debt trap

 

Owing taxes can lead to long-term trouble. Taxpayers who are out of work or have other problems often end up with a bill they can't pay right away. Accrued interest and penalties can significantly increase the amount owed.

 

Tax attorney Lu-Ann Dominguez in Fort Lauderdale, Fla., sees painful cases all the time in which debt issues snowballed because of insufficient withholding. Many of her clients weren't able to write the IRS a check, so they didn't file.

 

That leads to the world of IRS collections, which can involve tax liens, levies on wages and bank accounts, ruined credit and problems that last for years. In her work for the Gunster law firm, Dominguez has seen 50 tax liens for more than $100,000 in the past month, most involving individual taxpayers.

 

"To get a few bucks back is so much better than to risk going through what could end up being a collection nightmare," she says.

 

Providing a welcome windfall

 

Receiving a cash infusion every spring can provide a much-needed lift. After a year of focusing on living expenses, many taxpayers enjoy having some flexibility.

 

A big check doesn't have to be wasted. It's common to sink the money into home improvements, college savings or retirement accounts.

 

Like most other certified financial planners, John Rohrbeck isn't a fan of large refunds. He can accept it for some clients, however, as long as it is banked or otherwise set aside wisely.

 

"If they save it, invest it, use it to pay off debt, build their emergency fund, great," says Rohrbeck, president of Tax & Financial Strategies in Birmingham, Mich. "But if they spend it on another trip to Disney World or another big-screen TV -- bad idea."

 

Protection against tax surprises

 

Over-withholding can serve as a buffer against the unknown.

 

Actions you may not have anticipated when you set your withholding level can result in sizable tax hits. Taking money out of an individual retirement account or 401k or selling stock could push your tax return into the red. So could bonuses, corporate dividends or hefty moving expenses.

 

Many taxpayers also continue high withholding because of uncertainty about possible changes to the tax code.

 

It can be difficult to predict what you might owe if you have a complicated tax return.

 

If your taxable income varies widely, withholding enough to be on the safe side makes sense. No one wants to be on the hook for thousands of dollars in April.

 

Forced savings

 

Using a big refund as forced savings is a lazy but easy way to set money aside.

 

Personal finance blogger J.D. Roth, editor of the website Get Rich Slowly, confesses to liking lump-sum windfalls as a way to save. He used the approach for years as what he calls a psychological trick to remove the temptation to spend immediately, putting the annual checks toward savings, debt payments and indulgences he wouldn't otherwise have been able to pay for.

 

Roth has since sworn off getting large refunds and the "mathematical penalties" they entail after developing more willpower. But if the practice helps someone else avoid squandering their money, he's all for it.

 

"I would rather have people save money in a suboptimal way than to have them not

save money at all," he says.

 

Little lost opportunity cost

 

The meager interest rates offered by CDs and money-market savings accounts mean you're not missing out on much income by waiting to get your money.

 

That will change as rates rise, but they have a long way to go. One-year bank certificates of deposit pay an average of 0.34% and money markets average a scant 0.14%, according to Bankrate.com.

 

The Tax Institute at H&R Block ran the numbers for different scenarios and found that the opportunity cost for overpaying taxes isn't much at current interest rate levels.

 

Take the case of taxpayers who set aside $100 per pay period, or $2,400 over the course of a year. If they had put the full amount in an interest-bearing checking account with typical returns of 0.25 percent for a year instead, they would earn interest income of just $6.

 

That's a little over $5 after taxes -- not much of a disincentive against fat annual refund checks.

 

More from MSN Money:

VIDEO ON MSN MONEY

8Comments
Mar 29, 2012 9:13AM
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"r u kidding"... your post is horribly misleading. The only refund that is taxed the next year is STATE INCOME TAX and that is only true IF you itemize. Part of your itemization is deducting state income tax paid. Well I paid $2,000 so I deduct $2,000. I complete my 1040 and submit it to the IRS. Then I do my state return and see I get $500 back meaning I really only paid $1,500 in state income tax even though I told the IRS I paid $2,000. The next year I have to show $500 in income to make up for the "lie". You have to do it that way though because you have to do the federal return before you do the state return since every state I know uses the results of the federal return as their starting point.
Mar 29, 2012 9:22AM
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As for the story, you can come up with any excuse you want but refunds are bad. If you are responsible, plan accordingly, and save like you should, there is no reason to be happy about a refund. Sure interest rates are low but no one says you have to put that money into a savings account. You can invest it in the market and do much better. I made 5% return last year which is below the historic average. The year before that I made almost 19% and the year before that just over 32.5%. The average refund from what I hear is $3,000. That is $150, $570, and $975 respectively. Yes, I know the market can go down and you can lose money but on average the market has returned 8% ($240 on that $3,000 refund).
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This article is totally misleading. According to Webster's a refund is a return of money paid. Most of the so called "refunds" made by the IRS is actually the free money paid out through refundable credits. The refundable credits are the governments way of engineering the welfare system through the tax code. The $54 billion dollars of free money paid out is not a true refund since the receiver never paid any money into the IRS. It would be nice to see what the true refund amount would be after removing all the free money.
Mar 30, 2012 11:11AM
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We always liked the idea of getting tax refunds. Of coarse like everything it all depends on your financial situation.

Part of income comes from owning rental income properties. We both have regular jobs and have taxes taken out every paycheck. But the multitude of deductions available from our properties almost always insured that we would get a major portion of the taxes we paid came back to us in tax refunds.

As stated above it was like a forced savings program. Like most people when you don't have that extra money each week you don't plan on having / spending it no matter how good your intentions are to not spend it or save it.

The constant rising of everyday costs of living always seems that the extra money you might have by having less taxes taken out of your paycheck finds a place to go before savings.

Apr 2, 2012 6:45PM
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r u kidden...........the only time a tax refund is never taxable. However, if one claims a deduction for a state tax on their federal tax return and is later reimbursed by the state then they are responsible for correcting the situation. Here is how suck occurs. One prepares their federal return and claims they paid $1,000 in state income tax because that is what is shown on their W2. Once they prepare the state return they discover they only owed the state $900 the most common way of correcting the situation is to claim the $100 as income the following year. 
Mar 29, 2012 9:10AM
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r u kidding: the government gets you coming, and going.  There is no winning when it comes to the IRS.
Mar 29, 2012 8:56AM
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The only thing missing here is the fact that your tax refund is counted as income the following year. You earned it the previous year, was taxed on it and yet it becomes income the year the govt. returns it, huh????
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