Tax time is approaching and this year, like every year, I know plenty of people excited about receiving a tax return and discussing the exciting purchases they plan on making with this perceived windfall.
Each year I find myself biting my tongue and restraining myself from stating a true but unpopular fact: getting a tax return is not a good thing and is in fact the worst financial outcome of tax season.
This non-intuitive fact is often framed by stating that getting a tax refund is equivalent to the government paying back a one year interest-free loan. Conversely, owing money during tax season is equivalent to you paying back a one year interest-free loan to the government. When put in these terms, it seems obvious. So why don't more people feel this intuitively?
The answer comes down to simple human psychology. Our fallible brains view the sudden influx of money that accompanies a tax refund as a windfall, similar to if we had just received a check from a distant relative or found a $20 bill on the ground.
This is dangerous because most people invariably “categorize” money into different bins. The money we earn from work as part of our paycheck goes towards regular, boring adult stuff like paying the rent and bills, but windfalls and gifts are tucked away for fun purchases, such as new clothes or a vacation. This is, of course, completely irrational, but that doesn't stop us from doing it.
When it comes to tax season, the optimal outcome is actually to owe money, and the more the better! This is, again, counter-intuitive: who wants to owe money to the government? But remember that owing money during tax season means that you earned extra money during the rest of the year. Assuming you maintain good financial habits and are living below your means, that extra money was going into an interest-yielding savings account. When the tax bill comes due, you simply withdraw those funds to pay back the tax man. The kicker is that you get to keep all of the interest.
To put this into concrete numbers, let's evaluate 3 different scenarios: 1) you owe nothing and are owed nothing at tax time (that is, you paid exactly the correct amount of taxes during the previous tax year); 2) you owe $3,000 at tax season; and 3) you receive a $3,000 tax refund.
Again, for this analysis we are assuming that your income is more than enough to cover your living expenses and that you're making regular deposits into a savings account. If you are either a) not earning enough to save or b) spending too much to save then the following analysis won't apply (although the conclusion remains the same).
A $3,000 tax debit or credit means that each month you pocketed $250 more or less than you should have. To keep the math simple, we'll assume that you normally save $250 a month from your income. For example, if you earn $5,000 a month, you spend $4,750 a month on living expenses and put $250 in the bank. So if you pay an extra $250 in taxes each month, you're still spending $4,750 a month but saving nothing. If you pay $250 less in taxes each month, then you're now saving $500 a month.
The conclusion that we'll arrive at shortly doesn't depend on the numbers I gave above: these are provided simply to make the argument a bit less abstract. Regardless of how much or how little you currently save or earn, the important point is that if you pay less in taxes you save more, and if you pay more in taxes you save less.
Let's also assume that you're a smart saver and you use a bank with a high-yield savings account (current annual yields for savings accounts as of this writing are around 1.8% on the high end). Compounded monthly, your balance earns 0.15% interest each month.
When saving $250 a month, at the end of one year your bank account will have $3,024.87. Saving $500 a month gets you $6,049.75.
At the end of the year you file your taxes. In the first scenario, you break even and owe nothing and also receive no refund. You walk away with $3,024.87. In the second scenario, we owe $3,000 in taxes, which we simply subtract from our savings account, leaving us with $3,049.75. And finally in our third scenario, we have nothing in our savings account but we get a $3,000 tax refund, so we of course walk away with $3,000.
|Break Even||Taxes Owed||Tax Refund|
There you have it. Getting a tax refund is the worst financial outcome at tax time. Add to this the fact that your psychology will likely entice you to spend that $3,000 refund (which is your own hard-earned money and NOT a windfall!) on something you likely wouldn't have bought otherwise, which means you really end up even further behind.
Now you might say: “Okay, so there's a difference of less than $50. Big deal. Over one full year that's not much”. Let's see what happens if, instead of a high-yield savings account, we invested in a US stock index fund (which historically averages about 7%):
|Break Even||Taxes Owed||Tax Refund|
As you can see, the difference is much more dramatic.
The amount of taxes owed or refunded also matters. In our example, we assumed a $3,000 debit or credit, but if that had been say, $10,000 the difference would have been even more dramatic, providing $165.83 in a high-yield savings account and over $650 in a stock index fund.1
To put this in finance terms, this is essentially buying on margin using funds borrowed from the national government. Except, unlike in the finance world, this borrowing incurs no interest and there is never a margin call – it is essentially risk-free. If you have the financial stability to do so, this is not a bad way to (hyper) optimize your finances to earn a little extra money each year.
So this tax season, cross your fingers and hope that you get to write a check instead of receiving one, and smile to yourself knowing that math is on your side.
It's important to remember that stock index funds don't always provide a 7% return; that is simply the historical average. In 2019, a stock index fund yielded a return of 30.8% which would have resulted in an astounding $923.83 of interest for scenario 2; however, in a down year this is a very easy way to lose money. ↩︎