The Downside of Receiving a Tax Refund
Tax season—the most wonderful time of the year! Well, OK—it’s not exactly cinnamon-rolls-on-Christmas-morning wonderful, but this time of year means money is coming back into your pocket for many people. With the average refund clocking in at $3,536—it’s quite a good chunk coming your way. But is receiving a large tax refund good? Is there a downside to receiving a tax refund?
Here’s what we’re going to cover in this article:
- The myth of the big tax refund
- How taxes actually work
- The pros and cons of receiving a large tax refund
- How to create your own agenda based on what matters to you
First, let’s take a step back real quick. Taxes are a funny thing, and there are quite a few misconceptions about what’s a “good” tax refund or a “bad” tax refund.
The Myth of the Big Tax Refund
When Jesse (YNAB’s founder) was a CPA working at a large accounting firm, one of his colleagues—a CPA—said “Oh, I didn’t pay any taxes this year. I got a refund.”
Jesse almost lost his lunch. That’s not how tax refunds work!
What was the problem with his colleague’s statement? Even if they had just slipped up and really meant to say that they didn’t need to pay any additional taxes for the year…it was a wacky way of looking at taxes. See, a tax refund isn’t a gift! It means you’ve overpaid your taxes throughout the year, and the refund is simply the government paying you back money you’re owed.
How Taxes Actually Work
With taxes, most of us are trained to be refund-focused. We think about one number: either what we owe or are owed. We’re complying. We’re facing backward. But that’s not actually the whole story.
How taxes work:
- You earn money.
- You pay income taxes that are typically withheld from your paycheck automatically.
- During tax time, you calculate what you actually owe and either pay more (because your estimates weren’t enough) or you’re paid a refund (because you paid too much).
See, a tax refund isn’t free money! It’s not even technically extra money—that money has been yours all along!
Sure there are a couple cases where you won’t have taxes (low income, you’re dead, or you have tons and tons of kids), but the reality is that you’re going to pay taxes. Every year of your life. And when you die, you pay again. Don’t let me ever hear you say, “Oh, I didn’t pay taxes this year — I got a refund.” That’s just not how it works.
And if that concept gets lost on someone who passed the CPA exam, it certainly happens to your average Joe and Josie.
The Pros and Cons of Big Tax Refunds
The Downside of Receiving a Tax Refund
If you received a large tax refund, you’ve essentially given Uncle Sam an interest-free loan with your money.
If you got a large refund (remember, the average is around $3,500), that is not a gift you’ve been given. It means you’re sending more money to prepay taxes than you need to. You’re not keeping that money within your own decision-making powers. Sure, it’ll come back when you file taxes and receive your refund, but for many months out of the year, that money has not been working on your behalf for things like your investments, savings goals, or debt payoff.
Before jumping at a big return, do consider the actual financial cost of what else an extra bit of money could do for you each month.
The Upside of Receiving a Tax Refund
It’s not all bad though—a tax refund can offer a boost of motivation for a larger financial goal.
When it comes to your tax refund, there can be a real motivational boost in getting all that money all at one time. It’s a lump sum that could make you feel like you could finally afford to pay off that credit card, buy that car, take that vacation. This boost is missed if you go the drip drop route and get a smaller return.
As with many things in personal finance, the numbers might give a compelling argument for one course of action, but we cannot—no we cannot—forget about the emotional/behavioral/real life version of personal finance decisions either.
You Need to Have Your Own Agenda with a Tax Refund
I like to think of it like this: if you’ve ever eaten a Pizza Lunchable, you’ve got three little pizza crusts and nine pepperonis. Now there are two main strategies:
- Space pepperonis out evenly, three pepperonis for each pizza
- Put two pepperonis on the first two crusts, and then create a monster pile of pepperonis on the last pizza for ultimate delight
Which strategy do you prefer to eat your Pizza Lunchables?
That’s a very simple litmus test for deciding what agenda you want for your taxes. You’ll get nine pepperonis either way, but do you want to spread them out evenly or amass a big pepperoni-tastic pizza?
Put a more boring way: if you received a decent sized tax refund, ask yourself this question—would you rather:
- Have extra cash to use each month but get a smaller refund
- Have less cash to use each month but get a larger refund
And I say that all assuming your tax situation isn’t going to change too much between last year and this one. Throw in a house purchase, a baby, an increase in income, or a whole host of other events, and it’s not nearly such a clean equation. But what can we say, taxes are complicated!
How to Set Your Own Agenda for Taxes
So depending on if you want to be an evenly-spaced pepperoni taxpayer, or make your tax refund pepperoni-tastic, there may or may not be a downside to receiving a tax refund. Only you can decide your priorities (but do know your tradeoffs!).
- Run your numbers using this IRS withholding calculator to estimate next year’s refund. Do it thoroughly and you’ll have a clear idea of how much you’ll either be refunded or owe when you file your tax return if you change nothing this year.
- Adjust your tax withholdings to plan for a higher or lower refund (this can be done on your W-4 form if you work for an employer).
- Do your research and don’t be afraid to work with a tax professional or tax preparer to fine tune and optimize your tax liability.
- Celebrate your informed decision and actions come tax time!
Don’t stop there! Avoid these five common mistakes to avoid when you get your tax refund.
This is for educational purposes only and is not intended as tax or investment advice.