Should you aim for a big tax refund?
Taxpayers have filed their 1040 forms (or asked for extra time to file) for the 2008 tax season and are now sitting back and waiting for refunds.
Traditional advice has advocated that a big refund is bad, because it means that an investor paid too much in withholding or estimated taxes and gave the government a tax-free loan.
Instead, taxpayers have been told to adjust their withholding so that they pay in just enough to cover their taxes, allowing them to invest the rest of their money and earn extra interest.
Behavioral economists have begun to question this convention as they gain insight into how individuals use large amounts of money.
Save or spend?
Studies have shown that Americans tend to find it hard to save when they receive income periodically. A few dollars more a week in a paycheck is more likely to get spent than saved.
But when income comes in larger lump sums, it seems more significant and is more likely to be saved.
One study showed that workers who got part of their income in annual bonuses tended to save more money than those who got all of their pay weekly.
Also, the argument that someone who gets a big refund is giving up significant investment earnings is pretty weak in an era of low interest rates.
Suppose you have a savings account that yields 2 percent, which would even be a high yield in today’s market. Instead of having the average federal tax refund of about $2,500 withheld from your paycheck, you choose to take an extra $208 in monthly income. Each month that money goes right to your savings account.
Trivial earnings
The interest earned over the 12 month period amounts to a trivial $19.
So don’t feel bad about getting a refund, as long as you are determined to put a good part of it away.
The first choice should be to add to, or start, an emergency fund. Having several thousand dollars sitting in a certificate of deposit or money market fund can help you avoid borrowing for unexpected expenses.
The second choice is paying off debt, starting with high interest credit cards. If you have a good emergency fund and no debt, put the money away for retirement, preferably in a Roth IRA.