Why You Shouldn’t Consider Your Tax Refund as ‘Free Money’

A tax refund is the amount refunded if the tax paid exceeds the tax liability. In other words, if you qualify for a tax return, you will get back the excess amount paid as taxes in the previous year.

Employers withhold taxes, per the W-4 form. If the amount withheld is in excess of the taxes due, taxpayers get a refund at the end of the year. Self-employed individuals get a tax refund if they overpay the estimated taxes. On verification of information and tax details, the government approves the refund.

Most Americans Receive Tax Refunds

Despite understanding the nuances of tax refunds, the majority of Americans live under the delusion of treating tax refunds as free money. Personal consumer research shows that a good number of people think that tax refunds are a stroke of good fortune. This practice stems from the belief that tax refunds are indirect savings.

This is evident from how many Americans spend their refunds. A survey by ShopAtHome revealed that 29% of taxpayers with annual incomes below $35,000 spend their refund on extravagant purchases.

Another report by Time Business says that 58% of Americans file taxes in a way that they get a refund by the end of the year.

The surveys also show that people use their refund money to make bigger investments, such as financing a vacation or buying something exclusive.

But some people, especially millennials with huge credit card debt and other loans, avoid splurging and instead pay their bills with their refund. Meanwhile, many avoid the mountain of paperwork needed to file taxes where no extra amount will be withheld.

Should You Actually Celebrate a Tax Refund?

Well, it actually depends on how you may want to treat your refund money.

If someone has a lot of credit card debt, it may be seemingly easier to pay bills with the refund money. While paying off credit card debt is always a good idea, you could also think about changing your withholding. For instance, someone with a $3,000 balance on a credit card will end up paying nearly $540 in interest by making minimum monthly payments for a year, at an 18% interest rate. Meanwhile, if that person had less of their paycheck withheld so that he had an extra $300 per month to add to his minimum payment, he would be debt-free in a lesser number of months.

One should also bear in mind that tax refunds are equivalent to interest-free loans to the government. In other words, one is allowing the government to withhold a part of their income and is not even charging interest. Notably, a majority of U.S. households are running short of cash on hand. Per a few recent surveys by MarketWatch, 60% of the total household population has less than $1,000 in savings, which suggests that lending money, more so at 0%, is the most irrational step.

Bottom Line

The prudent approach toward tax refunds is not to have any excess money withheld, especially when liquid money is scarce. However, studying consumer psychology, the Obama administration issued a monthly tax refund that took care of both indirect savings and responsible spending.

For those who intend to save bigger amounts, they should opt for tax refunds, while people who need to meet everyday expenses should think about adjusting your withholding. In any case, “Death and taxes in life are certain, knowing how to pay only your fair share is third,” said Yvette D. Best.