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Everything You Know About Getting a Tax Refund Is Wrong

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Tax refund check
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Tax season is upon us once again. As usual, a chorus of advice-givers sounds its usual refrain: If you're expecting a big tax refund and feeling pretty pleased -- don't.

To hear the experts tell it -- MSN Money, The Wall Street Journal, even The Daily Beast -- whenever you get a big tax refund, it means you overpaid the government on your withholdings in the first place. It means you gave Uncle Sam a year-long "interest-free loan" of your money. And that big refund? It's just the government returning to you what was rightfully yours in the first place, keeping all the interest for itself, and all without so much as a "thank you."

But so what if it is? Is that even a bad thing?

The Common Wisdom

Most experts will tell you that the right way to do your tax planning is to have your employer withhold precisely enough money from your paychecks to ensure that you owe zero dollars and zero cents to the IRS at year-end. That way, on the one hand, you avoid paying interest and penalties on taxes owed come April 15. And, on the other hand, anything you do not actually owe, you can put in the bank to earn interest.

That advice used to make sense -- when banks were paying more than minimal interest on the money you kept in your account.

These days, though, thanks largely to Ben Bernanke's policy of quantitative easing, banks are paying only 0.5 percent on interest-bearing checking accounts on average (and many banks pay even less).

So say you're an average taxpayer, expecting a $2,700 tax refund (the average for last year). At 0.5 percent interest, you only lose about $13.50 in bank account interest by letting the government hang onto your money until refund time.

The Cold, Hard, Fiscal Truth

Of course, even a measly $13.50 is still money. Perhaps you'd like to keep it for yourself? But consider what might happen if you follow the experts' advice, and "play it smart" by not overpaying your taxes before they're due.

Say you hold onto that $2,700, put it in a bank, and earn your $13.50. But say you do more than that, miscalculate, and accidentally underpay your taxes by more than $1,000. In this case, yes, you'll earn your $13.50 in interest. You may even earn a bit more, depending on the size of the underpayment. But you might also end up paying a tax penalty six times as big as you earned in interest. This is because the IRS can assess a penalty of 3 percent on any underpayment of taxes.

Translated into dollars and cents: Underpay by $1,000, and you may be liable for $30 in tax penalties -- wiping out the money you earned in bank interest. Underpay by $2,700, and you'll get socked with an $81 penalty.

And Another Thing...

Low interest rates on bank accounts are the biggest reason it no longer makes sense to avoid getting tax refunds: The risk of penalties now heavily outweighing the benefits of collecting bank interest.

But there are other reasons to consider overpaying early, and getting a big refund at the end of the year.

Critics of tax refunds love to cite a 1994 study by the University of Michigan, which found that when consumers receive a cash "windfall" such as a big, one-time, lump-sum tax refund, they tend to spend it as fast as they get it. Such windfall cash, they say, is spent "twice as fast" as income received in a paycheck.

But a more recent study by MoneyRates.com finds that Americans simply don't waste their tax refunds like they used to. To the contrary, after surveying 1,100 American workers to find out whether they prefer tax refunds, or no refunds, MoneyRates learned that by a 2-to-1 margin (68 percent to 32 percent), most people prefer to get their money in one big lump-sum refund.

What's more, 69 percent of the people who prefer refunds use their refund money wisely -- taking the "windfall" and saving at least half of it. As MoneyRates explains: "People find it easier to save money when it comes to them in large chunks. When it arrives in small incremental pieces, it is too easy to just fritter the extra few dollars away."

The moral of the story: Don't let the experts make you feel guilty for getting a bid refund this tax year. Instead, take that refund and use it to pay down debt, to fund a retirement plan, or just sock the money away for a rainy day. Show the experts that you're smarter than they give you credit for.

Motley Fool contributing writer Rich Smith has no position in any stocks mentioned. The Motley Fool has no position in any stocks mentioned.​

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heather732

This article is completely bogus for one major reason. The IRS does NOT automatically assess fees or penalties if you underpay your taxes. They may, yes, but they do NOT as normal practice. We have had to pay for the past few years and there has been zero cost to us for doing so. So whatever refund I might have gotten has been safely tucked away earning interest - at more than 0.5%. I don't know where this guy is banking but he needs to do some homework. I never understand the point of these kinds of articles that are filled with such blatant misinformation.

February 19 2014 at 10:09 PM Report abuse rate up rate down Reply
1 reply to heather732's comment
jaded13640

I agree. It's as if they did a search to find the biggest moron and payed them to find contradictory information and write and article about it.

If you underpay you don't have to pay a penalty. Unless you don't have the money to pay it. Your taxes are due on April 15th. If you're already in the catagory that has calculated it out to end up paying zero extra every pay then you're probably in the same catagory that has a few buck in the bank to cover an error. Not to say that's aways the case by any means. But to suggest there's an automatic penalty if you didn't pay enough without bothering to mention the part about, "unless you pay the amount of the error" is nothing short of moronic.

February 19 2014 at 11:31 PM Report abuse rate up rate down Reply
ferrellfarmer

Nothingb should supprise you with King Insane Obumer ruining this country

February 19 2014 at 10:02 PM Report abuse +1 rate up rate down Reply
Mitch Welch

I read an article where an illegal immigrant received a $14,000 refund last year by claiming children that lived in Mexico.

February 19 2014 at 9:39 PM Report abuse rate up rate down Reply
2 replies to Mitch Welch's comment
ggblank1603

Well if you read it somewhere then it must be true

February 19 2014 at 9:59 PM Report abuse rate up rate down Reply
2 replies to ggblank1603's comment
jaded13640

well, yea, if it's on the internet it must be true. I read that on the internet.

February 19 2014 at 11:32 PM Report abuse rate up rate down
larry

Just like, If it came out of Obama's mouth it must be true. I'm hopeing the American people have learned their lesson when it comes to: "You can keep your healthcare if you like it, period" and "You can keep your Doctor if you like your Doctor, period". I wouldn't believe Obama even if his tongue came NOTORIZED.

February 19 2014 at 11:33 PM Report abuse rate up rate down
ferrellfarmer

Welcome to the HOPE AND CHANGE someone voted for can`t find anyone who voted for King Insnae Obumder now

February 19 2014 at 10:01 PM Report abuse rate up rate down Reply
Mitch Welch

Some of these folks getting nice returns are getting a child tax credit!

February 19 2014 at 9:38 PM Report abuse rate up rate down Reply
ROBERT J'S

Incorrect article, most big refunds go to people earning less than 14,000.00 per year, with alot of kids and no education

February 19 2014 at 8:50 PM Report abuse rate up rate down Reply
Tyler

what is killing the usa in this.not the guns but people coming here that are not from the usa trying to make a life but not paying tases's but still geting free every thing.I see this all over every day at food line with a food stamp card and cant speak English.and get payed under the table.now if the money goes to 10.10 a hour who will lose there job first?you ? me? hours will be cut more so they down have to pay ins on people.ok get obamacare ok.now were will the money come from to pay rent,tv,cell phone,this is the time we all have to help each other,,NOW! its going to get Bad.you think its bad now keep looking!
we are all or most of all of us trying to live.the only way to live happy is to have nothing,no tv no cell.add that up see what you are paying,a year.we did not have cell 15 years back we lived ok.you want to live better cut off the play stuff.we need to just look out for us and do what makes you happy.good luck all.

February 19 2014 at 8:42 PM Report abuse rate up rate down Reply
John Schlobohm

Used our refund to fund a Michigan retreat house for three families for a week this past August on lake Michigan.
Lived like Millionaires for 4 days in a fancy house and enjoyed every minute of it.!!

February 19 2014 at 8:24 PM Report abuse rate up rate down Reply
bcrnbs2

its simply, most people would reather pay in a little too much and not take a chanch on owing them anything. ..

February 19 2014 at 8:13 PM Report abuse rate up rate down Reply
1 reply to bcrnbs2's comment
jaded13640

Bingo but also, people aren't diciplined enough to save that money. If it's taken out of their check each week they money at the end of the year that they would not otherwise have at the end of the year. I'm guilty of it too. I had them take an extra 10 dollars a week just in case but also knowing I'd be getting it back. I never set it up so that there was a large refund. I think the largest refund I ever got was about 2500. That was an accident. I was at my highest wage at that point and worked a gob of overtime. The 2 and half large was nice but that was the last time I let the guberment hang onto that much of my money.

February 19 2014 at 11:56 PM Report abuse rate up rate down Reply
AGGIEBABA

If one is really disciplined to same money that they get in income by not having more withholding, then it might make sense to try and break even at the end of the year. Fact is, most Americans spend more than they make, and won't have that money at the end of the year. With .3% interest being paid by my credit union, for every $1,000 the Government keeps for the year loses me less than $3 in interest. Furthermore, anyone who believes that nonsense that it is better to not get a large tax refund should consider withholding enough so that they should owe the Irs as much money as possible without having any penalty, because that means that the Government is letting them have a free loan for the year. I call that stupid think, and will stick to my returns, which funds my vacations every year.

February 19 2014 at 7:10 PM Report abuse rate up rate down Reply
bdgrizcp

So here's a notion: many of us never get a big paycheck. No annual bonus, no big stock deals, and we hardly ever win contests. So getting a few extra bucks during the dark days of winter is a bit of a kick. It's like how some of us used to open Christmas Clubs to get cash for Christmas. It's like found money. It has nothing to do with micro-managing small amounts of money. Most of us don't account for every dime we make, if we did, Starbux would have far fewer outlets.

February 19 2014 at 6:48 PM Report abuse rate up rate down Reply
1 reply to bdgrizcp's comment
jaded13640

Very good point. For most people, even if they planned to save that money they were not giving the gov to hold every week, they more than likely wouldn't have it by tax time. When most people can't make it on what they earn how do you save? You can't. If they had an extra 30 buck a week in their checks they'd more than likely just get more channels on their cable subscription or go out to eat more or something. On paper it doesn't make sense to let the gov have an interest free loan but in reality it's money saved that most would not be able to save otherwise.

February 20 2014 at 12:00 AM Report abuse rate up rate down Reply