Everything You Know About Getting a Tax Refund Is Wrong

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Tax season is upon us once again. As usual, a chorus of advice-givers sounds its usual refrain: If you're expecting a big tax refund and feeling pretty pleased -- don't.

To hear the experts tell it -- MSN Money, The Wall Street Journal, even The Daily Beast -- whenever you get a big tax refund, it means you overpaid the government on your withholdings in the first place. It means you gave Uncle Sam a year-long "interest-free loan" of your money. And that big refund? It's just the government returning to you what was rightfully yours in the first place, keeping all the interest for itself, and all without so much as a "thank you."

But so what if it is? Is that even a bad thing?

The Common Wisdom

Most experts will tell you that the right way to do your tax planning is to have your employer withhold precisely enough money from your paychecks to ensure that you owe zero dollars and zero cents to the IRS at year-end. That way, on the one hand, you avoid paying interest and penalties on taxes owed come April 15. And, on the other hand, anything you do not actually owe, you can put in the bank to earn interest.

%VIRTUAL-article-sponsoredlinks%That advice used to make sense -- when banks were paying more than minimal interest on the money you kept in your account.

These days, though, thanks largely to Ben Bernanke's policy of quantitative easing, banks are paying only 0.5 percent on interest-bearing checking accounts on average (and many banks pay even less).

So say you're an average taxpayer, expecting a $2,700 tax refund (the average for last year). At 0.5 percent interest, you only lose about $13.50 in bank account interest by letting the government hang onto your money until refund time.

The Cold, Hard, Fiscal Truth

Of course, even a measly $13.50 is still money. Perhaps you'd like to keep it for yourself? But consider what might happen if you follow the experts' advice, and "play it smart" by not overpaying your taxes before they're due.

Say you hold onto that $2,700, put it in a bank, and earn your $13.50. But say you do more than that, miscalculate, and accidentally underpay your taxes by more than $1,000. In this case, yes, you'll earn your $13.50 in interest. You may even earn a bit more, depending on the size of the underpayment. But you might also end up paying a tax penalty six times as big as you earned in interest. This is because the IRS can assess a penalty of 3 percent on any underpayment of taxes.

Translated into dollars and cents: Underpay by $1,000, and you may be liable for $30 in tax penalties -- wiping out the money you earned in bank interest. Underpay by $2,700, and you'll get socked with an $81 penalty.

And Another Thing...

Low interest rates on bank accounts are the biggest reason it no longer makes sense to avoid getting tax refunds: The risk of penalties now heavily outweighing the benefits of collecting bank interest.

But there are other reasons to consider overpaying early, and getting a big refund at the end of the year.

Critics of tax refunds love to cite a 1994 study by the University of Michigan, which found that when consumers receive a cash "windfall" such as a big, one-time, lump-sum tax refund, they tend to spend it as fast as they get it. Such windfall cash, they say, is spent "twice as fast" as income received in a paycheck.

But a more recent study by MoneyRates.com finds that Americans simply don't waste their tax refunds like they used to. To the contrary, after surveying 1,100 American workers to find out whether they prefer tax refunds, or no refunds, MoneyRates learned that by a 2-to-1 margin (68 percent to 32 percent), most people prefer to get their money in one big lump-sum refund.

What's more, 69 percent of the people who prefer refunds use their refund money wisely -- taking the "windfall" and saving at least half of it. As MoneyRates explains: "People find it easier to save money when it comes to them in large chunks. When it arrives in small incremental pieces, it is too easy to just fritter the extra few dollars away."

The moral of the story: Don't let the experts make you feel guilty for getting a bid refund this tax year. Instead, take that refund and use it to pay down debt, to fund a retirement plan, or just sock the money away for a rainy day. Show the experts that you're smarter than they give you credit for.

Motley Fool contributing writer Rich Smith has no position in any stocks mentioned. The Motley Fool has no position in any stocks mentioned.​
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