Is Getting a Large Tax Refund Bad?

September 11, 2009 by Frugal Dad

with the following question regarding tax refunds and withholding:

I am a married sailor with two kids. I still have taxes taken out as though I were a single man. The reason I do this is because I lack the discipline to handle the extra money each pay check. It’s kind of nice to overpay every year and get the lump sum back from the government. Then my wife and I pay down some of our debt and move on. We don’t splurge with this money.

I’ve been told many times that I’m just giving the government an interest-free loan and that I should pay more down on my debt each month instead of once a year, but I’d like to get your thoughts on this.

There have been many debates about the practice of withholding too much in taxes to receive a large refund at the end of the year. I tend to agree with others who have advised that this is sort of like allowing the government to use your money, tax free, throughout the year and then return it to you at the end of the year.

A better way to think about it is to examine the opportunity costs associated with getting a large refund. Let’s assume your tax refund last year was $6,000. That works out to about $500 a month too much in taxes withheld from your pay.

If you dropped that $500 a month in an online savings account averaging a 3% yield, you’d have $6,100 after the first year. That’s $100 you’re missing out on each year just by having the government hold your money. But that’s not all.

If you used some or all of that money to pay down debt throughout the year, instead of waiting until the end of the year, you would likely pay less in interest charges, too.

There is also the issue of security. You didn’t mention an emergency fund in the mix, but this $500 a month would go a long way towards building a buffer between your family and the next financial emergency. If that same money is tied up in taxes, you won’t see it until February, and it won’t be available to help cover those inevitable expenses all households experience.

Having said all of that, I can appreciate the idea of using taxes as sort of a “forced” savings account. Often times we have to use things like this to protect ourselves from ourselves. If you will likely blow the $500 a month instead of socking it away, or using it to pay down debt, then over-paying taxes throughout the year and counting on a big refund might make sense. Still, I’d look for a way for you to control that money yourself and get some benefit from it.

Readers, what advice would you give Dan? Are any of you currently intentionally over-withholding taxes to generate a large refund?

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