A Big Tax Refund Is Never A Good Idea

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

A recent article I read in USA Today espoused, “Five reasons why a big tax refund can be a good idea”. I'm sorry, but no, stop the madness. Through March 10 of this year, the IRS has issued refunds of $174 billion for an average refund of $2,946. Let me lay this out for you, getting a nearly $3,000 refund from the IRS because you paid too much in taxes is never a good idea. The author of the article gives these five reasons that getting a big refund is a good idea. Let's look at each reason given and see why this makes no sense.

Avoids A Debt Trap & Protects Against Tax Surprises

The theory is individual taxpayers who don't have enough taxes withheld, can end up owing money to the IRS and can have problems paying this bill. To say that getting $3,000 back so you can avoid paying money to the IRS is a good idea, is just not well thought out. If you are getting a $3,000 refund, you are overpaying the government $250 a month. If you are worried about underpaying, then make an adjustment so you don't get as much back, but don't give the government your money every month with no interest. When it comes to tax surprises, the idea that you should continually loan the money to the government, at no interest, to avoid a potential surprise is just not smart. In addition, if these surprises, such as a larger bonus, or corporate dividends do come your way, do the smart thing and save some of this additional income to cover any potential tax consequences. With five minutes of tax planning, you should be able to make adjustments to put this extra money in your pocket every paycheck, instead of once a year when you file taxes.

Provides A Welcome Windfall

The author's contention is that this welcome windfall is used for home improvements, college savings, or retirement accounts. Here is the problem. There is a time value to money. If you could do a home improvement for $1,000, which would you rather do? Your first choice is you can save your extra $250 a month for 4 months, have the improvement done, and enjoy it for the remaining 8 months. Your second choice is, you can wait until you file taxes and then do the improvement. Why wait if you don't have to? The idea of putting this extra money in college savings or retirement accounts once a year is an even worse idea. Let's compare your returns if you invested this $250 once a month versus once a year in the following stocks:

<table> <tbody> <tr> <td> <p><strong>Name</strong></p> </td> <td> <p><strong>Number Of Shares End Of Year & Avg. Buy Price</strong></p> </td> <td> <p><strong>Capital Gains</strong></p> </td> <td> <p><strong>Dividends Received</strong></p> </td> <td> <p><strong>Total Return</strong></p> </td> </tr> <tr> <td> <p><strong>Walmart</strong> <span class="ticker" data-id="206096">(NYSE: <a href="http://caps.fool.com/Ticker/WMT.aspx">WMT</a>)</span></p> </td> <td> <p>55.14 shares - $54.54</p> </td> <td> <p>$336.90</p> </td> <td> <p>$36.24</p> </td> <td> <p>$373.14</p> </td> </tr> <tr> <td> <p><strong>Pfizer</strong> <span class="ticker" data-id="204972">(NYSE: <a href="http://caps.fool.com/Ticker/PFE.aspx">PFE</a>)</span></p> </td> <td> <p>154.83 shares - $19.45</p> </td> <td> <p>$464.49</p> </td> <td> <p>$77.29</p> </td> <td> <p>$541.78</p> </td> </tr> <tr> <td> <p><strong>Paychex</strong> <span class="ticker" data-id="204902">(NASDAQ: <a href="http://caps.fool.com/Ticker/PAYX.aspx">PAYX</a>)</span></p> </td> <td> <p>100.78 shares - $29.96</p> </td> <td> <p>$207.60</p> </td> <td> <p>$66.45</p> </td> <td> <p>$274.05</p> </td> </tr> </tbody> </table>

($250 of shares purchased on about the 25th of each month, dividends not reinvested. Capital gains are calculated based on average cost basis versus current stock price.) 

Your return if you waited to invest until you file taxes is $0. Since you wouldn't have owned the shares during the year, you collect no dividends, and you end up with no capital gains. As I think this proves, this windfall is better when you receive it divided between every paycheck. If you divided your $250 a month between these three companies, your average return would have been $396.32 or a 13.21% return. This is from 3 random companies in a year when the return of the S&P 500 was basically nothing.

Forced Savings

The idea of using the overpayment of taxes as a way to force someone to save, is one of the worst ideas I've heard. If someone has a problem saving, they would be better served to set aside money into Series I Savings Bonds each paycheck. Since these bonds cannot be cashed in for 12 months from the time you purchase them, this way you have the same effect as forced savings. The difference is you at least earn interest on the funds while you wait. With savings bonds, you also have the tax advantage of not having to pay taxes on the interest until you cash the bonds in.

Costs Little In Lost Opportunities

The idea that there isn't much lost in opportunities is just false. The author's example of putting the funds into an interest bearing checking account is foolish (small f). I don't know a financial planner in the country that would suggest putting extra funds into an interest checking. The above example of investing your funds into stocks for longer term gains (if you're going to put the funds into a college fund or a retirement account), already proves that there is plenty to lose by not having these funds up front. An additional problem with saying this extra $250 a month costs little in lost opportunities is, what about credit card debt? According to recent statistics, the average credit card debt per household is $15,956. The average interest rate on a card with a balance is 12.78% as of November 2011. So by not having this $250 a month to pay down credit card debt, your cost is $170.24 in interest in the first year. This is not a small amount lost if you don't have these funds during the year.

As you can see a big tax refund is not a good idea after all. If you are someone who got this nearly $3,000 refund, adjust your withholding, talk to a tax advisor and you'll do much better in the long run.

Motley Fool newsletter services recommend Paychex, Pfizer and Wal-Mart Stores. The Motley Fool owns shares of Wal-Mart Stores. MHenage has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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