Are Tax Refunds Good or Bad?

Mar 22

Has anyone ever told you that they were mad because their tax refund was smaller than last year? What about someone mad about owing money instead of getting a refund?

In a rational world, you should be happy you owe in (assuming no penalties) and be mad if you get a refund (ie: you gave the government a ‘free’ loan for a portion of the year and they are paying it back to you interest free).

 

People Don’t Think Rationally, No Matter What Economist Believe

Ms. Red to Riches had to pay the IRS during this tax season for the first time ever because her withholdings were lower than what she owed… and she was not happy about it.

We earn very similar wages from our primary employment. However, I’m getting a refund and she isn’t.

Why? Because she earned ~$8,000 more than me by side hustling… without paying any taxes on it throughout the year.

She understands the tax system, but still, human psychology prevails over rational thinking.

I’m getting a refund, so I ‘think’ of it as “free money” even though the money was always mine.

She has to pay money, even though it was never really her money. Our minds do now cope well with losses.

 

Psychology of Losses

Losing money hurts more than winning money.

Through my various readings, I recall that a loss has twice the impact of a gain. For example, winning $100 and losing $100 are not on the same scale in the realm of psychology. People hate having things taken away from them and the impact of a loss is greater than the impact of a gain.

If you have to pay the IRS $1,000 because you underpaid during the year, you feel like you are losing money, even though you really never earned a right to the money, as in Ms. Red to Riches’ case.

Anchoring (ie: using previous tax refunds as a point of reference when comparing the current year) is also important. She was conditioned to expect to get “free money” every March/April. When she didn’t, she was disappointed, even though it makes logical sense that she needs to pay in.

 

How to Reverse the Impact

Easy, pay quarterly taxes or set aside money in a separate savings account that is ear-marked for taxes.

(If you owe money, make sure to understand your situation and whether or not estimates are required to avoid penalties).

This will help mitigate the magnitude of your “loss” and maybe even counter it completely.

 

Don’t Treat Your Tax Refund as a Bonus!

Popular media loves to take advantage of your tax refund.

 

Buy a new car today! We’ll MATCH your tax refund up to $2,000!

Need new furniture? How about a TV? Bring your tax refund in today!

When people receive a relatively large sum of money, many decide to splurge and spend it right away (think of lottery winners). If that money was earned in small increments throughout the year (your tax refund really was earned throughout the year), would you make the same decision?

Think about it just like any other money you have.

What’s the best use of it?

Pay down debt! Beef up your emergency fund! Invest! Improve yourself through education or health!

 

What is Mr. Red to Riches Doing With His Refund?

I will be putting my tax refund into my savings account. Later in the year I may decide to use it to pay down debt, but for now, I want to provide my savings account with some extra cushion based on my current financial decision.

 

Did you get a refund or did you have to owe in? What do you do with your tax refund? If you owe in, how do you plan for it? Leave your thoughts below!

2 comments

  1. Personally, I think it’s better to neither get refund nor owe taxes. But that’s obviously hard to accomplish, especially if you have complex finances with various streams of income.

    But between getting a refund or owing, I’d rather get a refund… the interest you’d have made on your refund (had the money been in your possession all along) would have been a pittance (unless your refund is huge, in which case, why?). I’d gladly “pay” that little bit of interest instead of being surprised by an unexpected tax bill… which might put a damper on your plans. My point is that it’s easier to plan around a refund than a bill whose amount you don’t know.

    I got a refund this year 😉

  2. Like most financial strategies, I don’t think there is a definite answer on which strategy is best. For example if someone is a terrible saver, it might make more sense for them to pay more in taxes then get a large refund. That is if they then save the refund. I figure out my taxes in advance and pay just enough so I am a break even each tax year.

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