Is It Better to Get a Tax Refund or Owe the IRS?

Ah, the age old question – is it better to get a tax refund or owe the IRS each year when April 15th comes around?

Let’s sit down and see if we can discuss it from both sides of the argument to answer the question: is it better to get a tax refund or owe the IRS.

Taxes – To Give or Receive?

I will start out by saying that for the 2014 tax season, we ended up getting a pretty nice refund – about $1,700!  That’s very nice considering I thought we would actually end up owing money.  For 2013 I think we owed around $1,000, and I just assumed things would be similar this time around.  So, should we make adjustments so that in 2015 we get all of our money up front each month, or is it better to get a fat check come April 15th, 2016?

It’s Better to Get a Tax Refund Argument

I dug up a couple interesting facts on tax refunds from Time magazine online recently.  Time states that about 75% of Americans actually receive a tax refund.  That’s pretty mind blowing and much higher than I would have expected.  The more interesting fact is that for 2013, 58% of Americans say they intentionally planned to receive a refund!  OK… this was a bit surprising to me given that the average refund for 2013 was $2,800 – that’s a lot of money to withhold throughout the year.  Why do folks plan to do this?

My guess is that it all comes down to the savings rate.  Most Americans cannot be trusted to save their own money.  According to TradingEconomics.com, the American savings rate is hovering around 5.5% for the past several months.  That’s not so great…  I think most Americans do not trust themselves to hold onto the money throughout the year and plan to use their taxes (over-payments) as a type of savings account.  Because many folks are living paycheck to paycheck, they simply cannot afford to pay a large tax bill at the end of the year if their income has already been blown on other things.

One other thing to take into account is that because the savings rate is so low in America, most people are actually managing their finances in such a way that they are counting on a refund to channel into their normal spending for big ticket items: a vacation, family computer, down-payment on a car, etc.  If this money were split up and handed out every two weeks, most people would not have the discipline to save it up for these bigger ticket purchases.  Instead, they’d blow it on soft drinks and wasted cable TV packages.

OK – so maybe getting a tax refund isn’t all that bad.

It’s Better to Owe the IRS When it Comes to Taxes

Let’s look at the flip side.  Many would scold folks for giving the government a free loan for a year.  Afterall, why let the government collect the interest instead of getting it for yourself? I think this argument made sense several years ago where the guaranteed rate of return on your money was > 4%.  These days, with the near zero interest rate policy (zirp), I am not so sure this argument holds much water.

Let’s look at a very simple example by using some of the info from above.  Let’s assume that instead of getting a $2,800 return, we elect to receive the $233.33 extra each month.  If we could invest this for free in the market and earn an annualized 7% return, that would be an extra $196 a year that we would make on interest.  I could make a pretty good argument that it would be worth our time to kick Uncle Sam to the curb, take the money, and proceed to run to the nearest exit.  But, it isn’t quite that simple for a number of reasons!

The first reason you wouldn’t actually be making $196 in interest is that you didn’t get the lump sum of $2,800 to invest for a full 12 months.  You only get $233.33 each month, so you’re not getting the full 7% annual return on $2,800!  Check out the table below to see what I mean…

Month	Monthly Extra	Total Extra @ 7% Annual Interest (0.6% monthly)
0	$            233.33	$     233.33
1	$            233.33	$     234.69
2	$            233.33	$     470.76
3	$            233.33	$     708.20
4	$            233.33	$     947.02
5	$            233.33	$  1,187.24
6	$            233.33	$  1,428.86
7	$            233.33	$  1,671.89
8	$            233.33	$  1,916.34
9	$            233.33	$  2,162.21
10	$            233.33	$  2,409.52
11	$            233.33	$  2,658.27
12	$            233.33	$  2,908.47

OK – so now we down to $108.47 extra interest each year if you plan to not receive a tax refund… Still probably worth our time.  But wait – there’s more!  We cannot go around investing in the Stock Market for free, can you?  Of course not!  Let’s assume we are charged $5 per transaction (most companies actually charge more) to buy some stock and we choose to buy monthly.  Now our table looks like this:

Month	Monthly Extra	Investing Fee	Total Extra @ 7% Annual Interest (0.6% monthly)
0	$            233.33	–	$     233.33
1	$            233.33	$              (5.00)	$     229.67
2	$            233.33	$              (5.00)	$     460.67
3	$            233.33	$              (5.00)	$     693.02
4	$            233.33	$              (5.00)	$     926.73
5	$            233.33	$              (5.00)	$  1,161.80
6	$            233.33	$              (5.00)	$  1,398.24
7	$            233.33	$              (5.00)	$  1,636.07
8	$            233.33	$              (5.00)	$  1,875.28
9	$            233.33	$              (5.00)	$  2,115.88
10	$            233.33	$              (5.00)	$  2,357.89
11	$            233.33	$              (5.00)	$  2,601.31
12	$            233.33	$              (5.00)	$  2,846.15

OK – we still came out $46 ahead.  That’s better than nothing right?  Well, you could always go to investing quarterly instead of monthly, but you would miss out of 3 months of interest each quarter while you tried to minimize your transaction fees.  Here’s what that looks like:

Quarter	Quarterly Extra	Investing Fee	Total Extra @ 7% Annual Interest (1.8% quarterly)
0	$              700.00	–	$     700.00
1	$              700.00	$             (5.00)	$     707.16
2	$              700.00	$             (5.00)	$  1,426.70
3	$              700.00	$             (5.00)	$  2,158.83
4	$              700.00	$             (5.00)	$  2,903.77

Following this method, we’re able to make about $104 for the year off of interest…

One-hundred Bucks is One-Hundred Bucks, Right?

So, do the folks that say it’s better to owe the IRS on taxes win the argument?  Not so fast!  For the 80%+ of Americans that live paycheck to paycheck, you could easily have your portfolio be down at the time of the year when you need the money.  It isn’t uncommon for the stock market to be down 10%, 20%, or more.  So, if you needed the money for normal annual expenses, you could easily lose quite a hefty sum if you needed to cash it out at an inopportune time.  The Stock Market is really only a good idea if you are planning to keep your investment in the market for > 5 years.  I am sure you’ve heard that before…

Is It Better to Get a Tax Refund or Owe the IRS? – Conclusion

Put all of this together, and what does it all mean?  I would argue that in today’s near zero interest rate environment, it does not really matter which approach you take!  That’s right, do whatever you want 🙂  How often do you hear that as financial advice.  You will come out about the same under either scenario for the average person.  Things too keep in mind that could change the advice would be:

• the size of your return (the higher your annual return, the more I would lean towards modifying your withholding to invest it each month).
• the risk free rate of return you could get from a bank in a savings account.  Obviously, if we were back in the 80’s and you could get 10% – 15% return from a savings account, you would want to take the money and give the IRS the middle finger 🙂
• If you will actually need to money for expenses in the next five year.  If so, it’s probably a risky idea to invest the money in the stock market.

Is it better to get a tax refund or owe the IRS in today’s low interest environment – you decide!