Why Your Big Tax Refund Is Like Flushing Money Down The Toilet

Every year between January and April it seems everyone gets excited about a big tax refund they expect to receive. This has always baffled me. Is it because I don’t like money? Or maybe it’s because I don’t like to see other people have money. The real reason is because tax refunds are interest free loans made to the government and wouldn’t that money be better off in your pocket?

The average tax refund for 2009 was $3,036, which means tax payers could have had an extra $253 a month if they had proper tax planning. Some people may not think this is a big deal, but let’s look at how much money we would have if we invested that money each month. At the end of each month we invest the $253 into a Roth IRA which will grow tax free. At the end of year one, we’ll have $4,801, or an extra $1,765. If we continue this over a ten year period, you would have $32,421,928! Seriously. Now, if you waited until the end of the year to get your $3,036 tax refund and then invested that at the same rate as above for ten years, you would only have $43,981.

I realize that this scenario might seem ridiculous because our tax situations change and we may not be able to invest all of the money each month for ten or more years. But don’t you want to try? You could be a multimillionaire in just ten years!

I said in the title to this post that a big tax refund is like flushing money down the toilet. The money down the toilet is the interest not being earned. A very simple solution to this is to fill out a new W-4 at work and change the number of allowances. This form has instructions that can walk you through how many allowances you should claim (the more you claim, the less money taken out of your paycheck), but often times you will still get a big refund at the end of the year because the calculations don’t take into account tax credits and deductions. The best bet is to consult a tax professional who can help save you the most amount of money by planning for every available credit and deduction.

Here is the other big reason I hear why people love their big refunds: “It’s a forced saving plan which keeps me from spending it on things I don’t need”. As I’ve shown above, it’s not a very good savings plan. And let’s all be honest for a second, how much of our refund goes into savings? We all want that money to go into savings, but most of it ends up in the hands of retailers. This is why I advise people to automatically invest part of their paycheck in their Roth IRA or other savings vehicle. You’ll never see that money and therefore won’t miss it, and if you put it into your Roth, it will grow tax free. I’ll tell you why a Roth IRA is so great in a later post.

So after reading this, I want you to go into work tomorrow and fill out a new W-4 and see if you can’t lower how much tax is taken out of your paycheck. Just compare how many allowances you currently have with what the new W-4 calculates (to find how many allowances you currently have just look at your current paycheck). More importantly, talk to a tax professional who will be able to help lower your yearend tax liability and save you even more.