Money Match-Up: Should You Get a Tax Refund?
Here's the latest post in the Rockstar Finance Money Match-Up series where two money bloggers argue opposite sides of an issue. Today's issue features another interesting debate -- should you get a tax refund or not? We'll begin with Bull in Captivity who says you should get one...
The Case for Getting a Tax Refund
Choosing to receive a tax refund is right up there with buying a home, paying off a low-interest rate mortgage, or owning a pickup truck in the personal finance community. The opposing case against tax refunds is simple. Don’t give an interest-free loan to Uncle Sam. Case closed. This reasoning is entirely rational and a textbook decision from an economic theory standpoint. The problem though: humans are not rational. While there are decisions that look great on paper and are easy to prove with some simple math, decades of research on investment behavior shows humans don’t act rationally, especially with money. Maybe we get close, some may even act rationally in one financial area or another, but overall…irrational. Humans are emotional. Our minds make us think about concrete things like money in emotional ways. It’s not $100 in the bank; it’s your $100; a subtle, but important distinction related to the endowment effect. You worked for that greenback, so it has a unique value to you. What if you didn’t have to work for the $100 bill? What if you found it on the ground outside? More apt to treat it differently than if you did work for it? Probably. This is completely irrational because it is still $100 regardless of whether it was earned or not.
Mental Accounting
Even though money has a fixed value, we mentally sort it into accounts depending on its source. This is called mental accounting. Take two mental accounts: “salary” and “money for long-term investments.” When tested, investors are more willing to spend money they consider “salary” over money that they consider “long-term.” It is pure perception. The money is the same, the difference is how and when it is received. An example of how mental accounting works is the receipt of a bonus. Economists have found that a bonus is not treated as “salary” by investors even though it is income. Instead, investors tend to mentally classify a bonus in the “money for long-term investments” account. Because of this, the money is less likely to be spent and more likely to be saved. Weird right? The decision to receive $5,000 spread out over the entire year or $5,000 in one lump sum will determine how you treat that $5,000. Taking this irrationality into account, an investor receiving the $5,000 spread out over the year will treat the money as “salary” and will dip into this account first if there are expenses that pop up. These findings are consistent with other types of behavioral finance “tricks.” When employees have automatic deductions to retirement before they receive their paycheck, their savings rate is higher than if they had to save after they received the paycheck. If the money never hits the checking account, then the money never became “salary” and is not easily accessible both physically and mentally.
Uncle Sam
So how do these findings relate to the interest-free loan to Uncle Sam? We as investors are irrational and will likely spend the would-be-refund “salary” money or at least some of it throughout the year. How much we spend will vary, but it is reasonable to assume that the amount lost to mental biases like mental accounting will outweigh the opportunity cost that is commonly used to argue against a tax refund. The main argument against a tax refund centers around the opportunity cost or the returns you are missing out on due to taking the refund at the end of the year. The first non-behavioral problem with this argument is the assumption of earning the market return (opportunity cost of taking the refund), the money needs to be invested regularly meaning transaction costs every paycheck. Transaction costs may not be a problem if you can increase retirement contributions by the same amount and get free trades, but a consideration, especially since these regular contributions, are small and trading costs fixed. The next issue is the return itself. Sure you could earn 7% on the market, but that assumes you invest every dollar at the beginning of the year. This isn’t the case since you’ll be receiving your refund throughout the year. On average, only half of the money is invested at any one time, so the return is cut in half.
Closing Arguments for a Refund
I could continue to nitpick at the usual arguments for a no refund lifestyle, but overshadowing any point I make is the irrationality of investors. In the case of receiving a tax refund, you have two substantial behavioral factors working in your favor. First, by taking the money as a lump sum refund, it is less likely to be spent on poor financial choices. It never touches the bank account, so it can’t be used for drinks on Friday, or to speed up the timeline on some car maintenance. Second, by receiving the lump sum, mentally it is already classified as long-term money because its source is not a salary paycheck. Because of this mental accounting, it is more likely that you will spend money received from a tax refund for the financial good than if you received the same amount in pieces throughout the year where it could more easily be lost to expenses. I would love to walk into my Intro to Finance course and tell my students that they should avoid tax refunds, never sell when the market drops, or never pay off debt with an interest rate below the expected market return. Unfortunately, these decisions eliminate the human element of financial decision making that has whittled away at rational economic theory for decades. I, along with other financial economists, would argue that these behavioral factors outweigh any benefits of not receiving a refund, namely the potential investment returns earned throughout the tax year. ------------------------------------------------------------------ Now we'll hear from Accidental Fire who says you should not receive a tax refund...
The Case for Not Getting a Tax Refund
When you get a tax refund the government is giving you back money that they should not have taken from you in the first place. Worse yet, they're giving you back less than they took, since inflation has eroded it. If your tax refund from Uncle Sam in 2017 was $3000 (the approximate average in America), you actually agreed to this hypothetical conversation with Uncle Sam at the start of last year:
Uncle Sam: "So, I'm going to borrow $3032 from you this year, in 26 biweekly installments of $116.61. Cool?"
You: "Uh, okay, cool. You are going to pay me back though right? With interest?"
Uncle Sam: "No. I will pay you back, but not only will I not give you interest, I will only give you back $3000 of the $3032 I'm borrowing."
You: "Uh, hmmmm. So you’re going to steal $32 from me? Okay, I guess. Sounds good. If I need access to the money during the year though for like, an emergency, I can get it right?"
Uncle Sam: "No, absolutely not. I won't give you back your $3000 until next April, maybe May or even June."
You: "Uh, wow.....okay. Hmmm.... Well, sure, why not…"
Why is Uncle Sam giving you back less than the $3032 he borrowed? Because inflation was 2.1% in 2017, so while your money was being held hostage from you its value was being eroded. ($3032 * 1.05% = $31.84. Since you're lending money to Uncle Sam in 26 bi-weekly installments all of your money wasn't being eroded the whole year, so I cut the inflation rate in half to adjust.) Why would you do this? What part of this deal is good for you in any way shape or form? Let's look at it differently - would you buy a $3000 CD with a 16 month term if it matured to $2937? No? That would be a CD that gives you no interest and actually loses money to a 2.1% inflation rate ($63 loss). And you can't get access to the money for 16 months. Getting a tax refund is the doing the same thing. You get back less and your money is locked away from you and cannot be used.
Opportunity Cost
The stock market averages about 7% annually over time, plain and simple. So in addition to losing money by letting Uncle Sam hold it hostage, you are also losing the opportunity of making money in the stock market with those same dollars. So let's review this again -
- In a tax refund situation - Uncle Sam takes $3032 dollars from you and gives you back $3000 about 16 months later. And you don't have access to the money during those 16 months.
- In a non-tax refund situation - you plug that $3032 into your VTSAX as it comes in during the year and make 3.5% on average (again, I cut 7% in half since you wouldn't have that full amount on January 1st). So your $3032 becomes $3138
That's $138 dollars extra from simply adjusting some numbers on your W4. And just as importantly, you have access to the money if something big happens in your life. I'd argue the latter is almost more important. No one should take your money and not give you access to it unless you're getting interest. I've read article defending tax refunds, so let's look at a few of the main reasons people justify it.
“It forces me to save.”
Really? So you have to lose money as a mechanism to enforce yourself to save it? The first question I would ask to those who use this argument is - are you really saving and investing all of it the next year when you finally get it back? If so, ok, great. But here's a much smarter way of forcing yourself to save - just open up a high interest savings account at a bank and have that same $116.61 be automatically deposited in it each paycheck. As of this post, some online banks have rates as high as 1.9 – 2.0%, close to the inflation rate. If you do this you'll never see the money, so it's the same as Uncle Sam taking it. Except, you'll actually be making some money on it (or minimizing your losses if your interest rate is still less than the inflation rate). But bigger still - you'll have access to the money if you need it! It's not being held hostage. Then the following April you can simply log on to your account, look at your money, and pretend it's your tax refund. But you'll have more than you did if Uncle Sam held it hostage. Better yet, plug your $116 in VTSAX every paycheck with an automatic deposit. The market averages 7% a year.
“I like the psychological boost of a big windfall.”
This is incredibly poor thinking. First of all, it's not a windfall if it was your money all along. You have to remember, you are only getting back what was yours all along, and of course slightly less as I've shown. Secondly, if you want a psychological boost, then adjust your W-4 so you get all of your money now, and set up automatic investments into your index funds and watch them grow every month! That's the psychological boost that you should be getting, which is your money in your hands now being invested where it should be invested - in the stock market, to make you more. Make a simple cool bar chart in excel showing the growth of your investment over time, that's the psychological boost you need. And you can view it whenever, unlike a one-time 'boost' that gives you back less money than you started with.
“My tax situation is far too complicated.”
Okay, this is the one excuse that I do understand and that can be legit. Perhaps you have a few businesses, rental houses, farm subsidies, and alimony payments from a divorce. Things can get complex, I get it. Situations like this would make it extremely difficult to compute the proper deductions to make sure Uncle Sam isn't ripping you off. But in this case you should not be choosing to give the government a free loan, you're saying that your situation is so complex that you can't figure out the right W4 adjustments to prevent Uncle Sam from taking too much. That's understandable, especially if the various complexities are changing every year. In this case I'd argue it would be worth it to hire a good tax pro and still aim to have to pay a minimal extra amount after doing taxes. Bottom Line - It's better to keep your money under your mattress than get a refund. Assuming a bi-weekly paycheck, the average American is letting Uncle Sam take $116 extra away from them every check and holding it hostage, only to give them back less in 16 months. If you adjusted your W4 and put that same $116 under your mattress every paycheck, you'll end up with the same amount of money the following April. In both cases the money will have been eroded from inflation. But at least with the mattress strategy, if your daughter breaks her arm or you have unexpected car repairs, you have access to the money. ------------------------------------------------------------------ So, those are the two sides of the issue. What do you think?