*The following is based on scenarios encountered in the United States, subject to the income tax system of the United States as of the time of this post. These ideas might not apply to you depending on where you live and work*
I believe that most people would prefer to get money instead giving up money. I also believe that if people had to give money, they would prefer to give less than more (outside of charity, gifts, etc.). Rational people in a modern economy are not likely to spend $700 on a TV if they can get the same TV for $500. Rational people would rather spend $0.90 on ramen noodles than spend $2.00 on ramen noodles, all other things being equal. By the same logic, rational people would not pay more in taxes if they can get away with paying less in taxes. Unless…they would. Allow me to illustrate.
But first, I want to clear the air. I know that some folks are self-aware enough that they would rather receive a refund at tax time, even if it means that they lose out on the tax advantages I outline below. They know that if they had more money in their checks throughout the year, they would just blow their funds irresponsibly, and that receiving a lump-sum refund helps them be more budget-conscious. With that in mind, I know that some people will choose to pay more in taxes and get their refund because “it just works” for them. I am not a fan of this strategy, but I understand that some people don’t have a strong grasp on their budget or spending habits, as I once had the same problem. Hopefully they change their minds later on down the road, but I understand.
With that out of the way, let’s cover what a tax refund is, and why you might be owed a refund. Throughout the year, in the United States of America, you owe the federal government, and sometimes state and local governments, a percentage of your income. I don’t like it, most people don’t like it, but that’s the reality at the moment. Based on the amount you make, or the amount you are expected to make, a certain amount of money is owed to the government out of your paycheck or other sources of income. Your employer withholds this money from your check and pays it to the government on your behalf. If you are self-employed, you have to take care of that part on your own.
It’s difficult to predict exactly how much money you will owe the government at the end of the year because every person’s tax deductions and exemptions differ. It’s also impossible to predict exactly how much money you will make during the year. So in almost every case, you will either owe the government more tax money when you file your tax paperwork because you did not pay enough, or the government will owe you a tax refund because too much money was taken out of your checks compared to the amount that you actually owe.
Usually people enjoy getting a tax refund because that means they get a nice check from the US government, and it’s like a little bonus once a year. Many people even plan for it, and begin brainstorming what they’re going to use their tax refund for each year. “Hm, I think this year I’m going to use my tax refund to pay off my credit card. Maybe I should buy that new computer I’ve been looking at instead. I need my computer for school and my old one is barely even functional at this point. Then again, I really want to start investing my money. Should I stick it in the stock market? Decisions, decisions…”
On the contrary, some people find that, even though they’ve been paying taxes out of their paychecks the entire year, they owe more money to the government after their accountant finishes filing their taxes. This can be quite a wrench in the gears of any plans to use a tax refund for upcoming expenses or splurges that you’ve been putting off. It can also be rough if money is already tight, and the tax you now owe becomes the upcoming expense you have to pay off, and you didn’t budget for it, and you have to figure out how to pay this new bill.
Now, why on Earth would anybody want to pay MORE taxes at tax time instead of throughout the year? Well that all depends on your situation when it comes to your taxable income, tax deductions, exemptions, tax credits, and your overall tax liability. I’ll cover these terms quickly here, but this is just the surface of these tax concepts.
Your taxable income is the amount of your income that is subject to income tax. If you make $30,000 in a year then your taxable income is $30,000 if you don’t have any deductions or exemptions. Now an exemption is a kind of income that is not subject to tax. Let’s say that you had a certain bond that paid you $1,000 of tax-exempt interest in the year, and your job paid you $29,000. You would still have an income of $30,000, but now only $29,000 of that income is subject to income tax. Your income exemption reduced your taxable income.
A deduction is a tax tool that further lowers your taxable income. Sometimes these deductions are earned through certain activities, sometimes they are given to you based on your marital status, age, citizenship status, and other factors. So let’s say your taxable income is now $29,000, and you qualify for $14,000 in total tax deductions. That means your taxable income is now $29,000 – $14,000 = $15,000. Even though you made $30,000 in the year, you only have to pay taxes on $15,000 of that income.
Tax credits are a different story. They don’t reduce your taxable income, they only reduce your tax liability. Your tax liability is another term for the amount of tax money you owe. So if you have $15,000 in taxable income after the deductions and exemptions mentioned earlier, and your tax rate is only 10% (for the ease of this example I’m using %10, expect yours to be higher), then your tax liability is $1,500 for the year. This means that you will owe the government $1,500 of your income, spread out throughout the year and taken out of each check. A tax credit is applied after you find out what your tax liability is at tax time, and reduces it one dollar at a time. If you understand the difference between tax deductions and tax credits, this is where my primary reason for preferring to avoid a refund lies: Unless it’s a refundable credit, you can only take advantage of tax credits if you owe taxes when you file. If you’ve over-paid and are owed a tax refund check, you cannot use non-refundable tax credits to get an even larger refund. So they reduce the amount you owe at tax time, but they don’t increase your refund.
To make that a little more clear, let’s take all the concepts mentioned so far, and put them through two scenarios.
Scenario 1: Your tax liability is $1,500. Your W-2 says that you have already paid the government $1,800. That means you are now owed a refund check of $300. You get your refund, and you’ve paid $1,500 in total taxes for the previous year.
Scenario 2: Your tax liability is $1,500. Your W-2 says that you have only paid $1,000, so you now owe the government another $500. But since you owe money at tax time, you can take advantage of non-refundable tax credits (assuming you qualify for them). Say you qualify for a non-refundable tax credit that is worth $300. Now you only owe the government another $200. So you write them a check, and you’re bummed that you didn’t get a refund. But that means that you only paid the government $1,200 for the previous year. You owed money at tax time, and paid less in taxes than the person in scenario 1 who got a refund.
Now there are a lot of other factors that come into play here, like which credits you qualify for, and refundable credits, and so on, but this is the biggest reason why it’s better, in my opinion, not to get a refund check; you can end up paying more in taxes when you get a refund check.
Even if the amount you pay ends up being the same in the end, there’s still a big difference: owing the government money at the end of tax time means they didn’t get to enjoy the benefit of using your cash throughout the year. Wait….huh?
When you pay taxes, your cash goes to the government. If you pay more than you have to, the government gets to hold, invest, loan, spend, or do otherwise what they want with your cash until tax time. They don’t pay you interest on the extra money that they’re going to give back to you later. The government gets an interest free loan from you when you overpay throughout the year. You might get a refund in the end, but in the meantime they’re using your cash, and they don’t give you any interest. If you took out a loan, you would have to pay the bank interest for using their money. Same with a credit card if you carry a balance over your statement cycle. The bank would charge you interest for this. Additionally, if you owe the government money and don’t pay them fast enough, they charge you a penalty for not giving them what you owe. But do you get paid anything extra for the government having taken your money and held onto it for the better part of year? No. Why do you have to pay interest anytime you benefit from using somebody else’s cash, but the government doesn’t have to do the same? Sure, there’s the discussion of risk and efficacy that could be had, but if you locked your money away in an account or investment that would pay you interest or dividends, you would be better off financially than if you let the government take it and not give you any interest in return.
Finally, there is the issue of the time value of money. The short and overly-simplistic explanation is that things are more useful, or valuable, now than later. It’s more useful for you to have $100 today instead of $100 a year from today. If you have it today, you can benefit from it today through investing, to make more money in the form of interest, dividends, or capital gains, or from spending it. Think of it in terms of using an object rather than money. If you have a bicycle today, you can begin riding it. You can ride it every day for the next year and enjoy its utility for 365 days. If you don’t receive it until a year from today, it is less useful to you, because for the next 365 days you can’t enjoy its utility. We all have a limited time on Earth. That limit is one of the reasons why it’s more valuable, more useful, to have something sooner than later.
If the government has your money now, and will refund it to you later, the government is getting its use out of it, while you sit and wait to get it back. This might not seem like a big enough deal to start strategizing to under pay on your taxes with each check, but it is still a reason why you are realizing less of a net benefit by paying more upfront and getting a refund later.
Hopefully this made sense to you. If not, leave a comment below and maybe I can clear things up a little bit more. Thanks for reading.
Lance Out Loud 