How Much Did That Tax Refund Cost You?

This is the time of year that everyone in the US files their taxes and either owe money or get a refund.  Unless of course they perfectly set up their withholding for the year and ended up with a nice $0 at the bottom of their tax return.  If  your final result is a tax refund, that means you paid the government too much over the course of the year and let them hold onto your money until taxes were filed, at which point they returned it to you in the form of a refund.  I often see this referred to as “giving an interest-free loan to the government” and is almost always explained as a negative, or at least less than optimal.

The real impact of that tax refund can only be determined if you know what you would have done with the money as it arrived in your bank account over the past year, instead of as a lump sum at the end.  If it would have disappeared amongst the rest of your money and spent in a way that only brings temporary joy (a lot of spending falls in this bucket), that “interest-free” loan might be the best way for you to separate out a part of your income for saving.  Many Americans do end up using tax withholding as a form of “forced savings” whether intentionally or not, but if the lump-sum received at the end just goes to more mindless spending, you don’t really come out ahead either way.

On the other hand, if you deliberately make a point to invest that tax refund (or put it towards debt), it might actually be in your best interest to withhold a little extra.  Of course if you wanted to be optimal, you’d actually withhold the minimum amount necessary to avoid under-withholding penalties and invest the extra gained per paycheck immediately.  How much a difference are we talking about between these two approaches though?  The opportunity cost of withholding extra taxes is exactly I aim to find out below.

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First, A Quick Tax Lesson

Based on a few conversations I’ve had about taxes, there seems to be a lot of confusion about how the basics of taxes work.  It’s true that taxes can be rather complicated in certain circumstances, but I think everyone can wrap their head around the following basics.

Note: This will primarily apply only to standard W-2 employees.

  1. The amount of federal taxes owed for any given year is based on a person’s (or couple’s) total income.
  2. The government doesn’t want to wait until the end of the year to receive these taxes, so they force everyone to essentially pay as they go.
    • These payments over the course of the year appear in the form of a “Federal Tax Withholding” out of every paycheck you receive.
  3. As you can never be certain of the amount you will owe until everything is finalized at the end of the year, these withholding amounts from each paycheck are estimated.
    • The way these amounts are estimated is based on a W-4 that was filled out by you (most likely when you joined your employer).
  4. At tax time, you determine exactly how much you should have paid in taxes for the previous year by filling out a tax return.
  5. The amount you should have paid is then compared against the total amount withheld from your paycheck to determine if you owe more or the government owes you money back.

There you have it folks, the tax refund isn’t extra money from a magical place.  It’s simply money that you gave to the government over the course of the year that they’re returning to you.  Understanding this simple fact may change some people’s reaction when they get a “huge refund” after filing taxes.

Let’s get back to the topic at hand and look at exactly what is lost every time you end up with a refund at the bottom of your tax return.

Where Can We Invest The Extra Money?

As I mentioned at the start, the only way to get a real advantage out of avoiding a large refund is to put that money somewhere it can grow on it’s own.  Mindlessly spending the extra money during the year versus spending it all at once after you get a refund doesn’t really make much of a difference in my eyes.

Maybe getting the latest gadget a couple months earlier makes a big difference to you, but the moment it gets boring or you move onto the next cool thing might happen a couple months earlier just the same.  At least that’s what I’ve noticed happens to me whenever I chase short-term gratification in the form of stuff.

On the other hand, if you’re willing to hold out for the long-term satisfaction that comes with financial independence, it makes sense to invest the money in a way that it can grow.  By calibrating your federal tax withholding to minimize your refund, it’s possible to grow that extra money over the course of the year instead of waiting until taxes are filed the following year to get started.  Let’s look at some options to make that happen.

The bare minimum you should be looking for in an investment is 1% interest in the form of a high-yielding savings account.  The money is FDIC insured, you don’t have to put any effort in after opening the account, and the money is easily accessible at any time in the future.  Ally Bank is a well-reviewed example of this, but many other banks offer this type of account as well.

The next level of guaranteed returns I would look at is extra high interest accounts that require some work, but have the same FDIC guarantee as the previous bank accounts.  These accounts can return anywhere from 3-5% back on an annual basis, but you’ll have to jump through a few hoops to get them started and maintain them over time.  The best resource I’ve found for more information on these types of account is This Page on Higher Interest Accounts by Doctor of Credit.

The third option that offers guaranteed returns is putting the money towards existing debt.  Whether it’s a mortgage, auto loan, student debt, or even nasty high-interest debt such as credit cards you didn’t pay in full, the effective return received by putting extra money towards the principal is equal to the interest rate.

The more exciting option (and possibly easiest) for most would be to simply invest the money in the stock market.  In exchange for a little volatility (some years up and some years down), you can historically expect an average gain of 9% per year!  That number is based on the average true return of the SP500 since 1871, but of course past return does not guarantee future results.

These percentages are great, but what do they actually add up to over the course of a year if you take the extra money granted with each paycheck to invest instead of taking a lump sum tax refund?

The True Opportunity Cost of a Tax Refund

For the table below, I assumed any extra money gained (by not withholding extra federal taxes) over the course of a month (to standardize different pay structures) was invested at the very end of the month and left to grow until the beginning of April the following year (when a tax refund would be given).  Interest is compounded monthly on the starting balance for that month.

For example, someone who would normally have a $1,200 tax refund would invest $100 on January 31, another $100 on Feburary 28, another $100 at the end of March, and so on until $100 at the end of December.  This money then grows more until April 1st when it is then compared against their normal refund amount.

Here is the a full calculation for someone who would have received a $1,200 refund, but instead adjusted their withholding to get an extra $100 from their paycheck(s) each month and placed it in a 1% high-yield savings account.  As you can see, this allowed them to have an extra $8.53 in their account versus waiting for the tax refund to save.

Month Balance at Beginning Contributions Gains
Jan $0 $100.00 $0
Feb $100.00 $100.00 $0.08
Mar $200.08 $100.00 $0.17
Apr $300.25 $100.00 $0.25
May $400.50 $100.00 $0.33
Jun $500.83 $100.00 $0.42
Jul $601.25 $100.00 $0.50
Aug $701.75 $100.00 $0.58
Sep $802.34 $100.00 $0.67
Oct $903.01 $100.00 $0.75
Nov $1003.76 $100.00 $0.84
Dec $1104.59 $100.00 $0.92
Jan $1205.52 $0 $1.00
Feb $1206.52 $0 $1.01
Mar $1207.53 $0 $1.01
Apr $1208.53

In all honesty, $8.53 probably doesn’t seem worth the effort of adjusting your withholding.  In addition, it would require an extra bank transfer each month if you weren’t able to automatically direct-deposit just the extra amount into your savings account.

What about larger returns?  Will the power of compounding bump this number up enough to even justify this whole post in the first place?  Let’s look at the return for different refund amounts along with different possible gains that are possible.

Sample Tax Refund Opportunity Costs

Tax Refund
Expected Interest Rate $100 $500 $1000 $2000 $5000
1.00% (average high yield bank account) $0.71 $3.55 $7.10 $14.22 $31.36
2.00% $1.43 $7.14 $14.27 $28.54 $71.36
3.00% $2.15 $10.74 $21.49 $42.98 $107.44
4.00% (typical new mortgage rate) $2.88 $14.38 $28.76 $57.52 $143.79
5.00% (very high yield bank accounts) $3.61 $18.04 $36.08 $72.16 $180.41
6.00% $4.35 $21.73 $43.46 $86.92 $217.30
7.00% $5.09 $25.45 $50.89 $101.79 $254.47
8.00% $5.84 $29.19 $58.38 $116.76 $291.91
9.00% (historical S&P 500 returns) $6.59 $32.96 $65.93 $131.85 $329.63
10.00% $7.35 $36.76 $73.53 $147.06 $367.64
14.90% (average credit card APR) $11.16 $55.80 $111.60 $223.20 $557.99
23.24% (my highest APR credit card) $17.97 $89.83 $179.67 $359.34 $898.35

As you can see, a minimal tax refund won’t have a huge opportunity cost no matter how you use the money.  On the other hand, a larger tax refund that can be put towards high interest debt or invested in the stock market could yield hundreds of dollars every single year.

For example, if you typically have a high tax refund and carry any kind of high interest debt, you should definitely consider adjusting the tax withholding out of your paycheck and get access to that money sooner.  Otherwise you’re essentially throwing away money as you pay unnecessary interest!

While adjusting your withholding to it’s absolute minimum (or even below!) is “optimal”, you have to be honest with yourself when you set out to do it.  If you’re someone who thinks they would simply waste the money as it comes in and have nothing to show for it at tax time, maybe withholding extra works best for you.  This only works if you’re able to then apply the large tax refund towards debt, savings, or investments though, otherwise it’s pretty much a wash no matter what you withhold every year.

You know yourself better than anyone else, so take an honest look at your situation before deciding how you want to handle tax withholding and future tax refunds.  Before even looking into W-4’s, it might be best to get a handle on your overall spending before trying to perfectly optimize your investments or debt-payoff strategy.  It all links together in the end as a part of your overall finances, but some things will have a much bigger impact than others.

How To Adjust Your Withholding

If you looked at the opportunity cost chart above and decided you’d rather take advantage of getting the money sooner instead of waiting for your tax refund, the way to do that is to fill out a new W-4 form for your employer.

Every company will be a little different as far as filling out and submitting the form, but you should contact your HR department to figure out how your company handles it.  Once you figure out the process, I recommend using the IRS’s very own withholding calculator to help you fill it out for your own personal situation:

IRS Withholding Calulator

A copy of your most recent pay-stub will be useful in filling out the information requested.

After filling out their brief questionnaire, they will provide you with the exact numbers to put on the W-4 form to withhold the correct amount of taxes over the course of a year.

This Doesn’t Apply Simply to Tax Refunds

If we want to take this line of thinking a step further to think about what other kinds of opportunity costs were giving up, the calculation primarily remains the same.

The first thing that comes to mind is putting expenses on credit cards instead of paying with cash.  By putting the expense on the credit card and paying it off in full on the due date of each statement, we can essentially keep more money in our bank accounts at any given time and get paid interest on those amounts before the payments come due.  In other words, the banks are giving us an “interest-free loan” for a brief period of time.

For example, we spent around $40,000 outside of our mortgage last year and almost every cent of that was put on a credit card.  That means in an average month, we put ~$3,300 on credit cards that we didn’t have to pay off until 3 weeks into the next month.  The average number of days between making the purchase and the due date to pay it off ends up around ~36 days, but we’ll just say a month for simplicity.  If we utilize a high-yield checking account (such as LMCU which yields 3% up to $15,000) for our daily cash-flow (such as paying of our credit cards in full), the average daily balance of that account is $3,300 higher than it would be if we paid for everything with cash!  Ignoring compounding interest (which makes everything better), that’s an extra ~$100 per year without changing any of our spending.

The overall gain might not seem like a lot for opportunities like this and others, but make for small little optimizations that can be beneficial if you’re already taking advantage of all of the bigger ones such as utilizing tax-advantage accounts for your investments.

These same opportunities exist if you’re able to take advantage of 0% interest loan periods, but be careful to not overextend yourself or put the money in any kind of risk.

Am I the only one that thinks about optimizing every single dollar going in and out of our accounts?  How do you handle your tax withholding and refunds every year?  Let me know in the comment section below.


11 thoughts on “How Much Did That Tax Refund Cost You?

  1. Oh you’re definitely not the only one. I shoot for owing between $0 and $1000 (a sufficient but not necessary condition to avoid paying penalties). Unfortunately this is kinda hard for me to do because I get a $2750 fellowship payment either in January or December of the previous year. It’s really supposed to post in January (I’m a grad student, and it’s supposed to hit my account every fall and spring semester) but when it posts in December it can screw up my tax withholding calculations.
    I also try to squeeze as much value as I can out of any float I get. Short term float like credit card float doesn’t get invested in the stock market, but it stays in my 3% checking account at CCU (which can go up to 5% if you meet other requirements).

    God the most egregious thing people do with their tax returns is they think it’s “free money”. Drives me up a wall. And then you also see businesses take advantage of this mindset – tax refund sales!

    1. Sounds like you and I approach it in a very similar way. I shoot for a refund of under $500 because our deductions vary a little bit per year and that’s the amount I’m fine giving up the opportunity cost for.

      That fellowship payment sounds like a pain when it comes to taxes, but one thing that might help is taking advantage of the 100% of prior year’s taxes withheld to avoid penalties rule. If your prior year’s taxes didn’t include the fellowship payment (and thus you owed a lower amount), you can simply withhold the same amount for the current year (regardless of actual amount owed), “invest” the difference in something risk-free (like your CCU account), and just pay the correct amount owed at tax time.

      1. That’s true. But the $1000 safe harbor is worth more than the last year provision because $2750 taxed at a 25% marginal rate is $687.50.

        1. Bear with me as I venture into this hypothetical, but by counting the $2750 twice we can get a slightly larger buffer.

          Year 1: No fellowship payment (missed on both ends), Income = $X, Taxes = $Y = 25% of $X
          Year 2: 2 fellowship payments (Jan as expected and again unexpectedly in Dec, Income = $X + $5500, Taxes = $Y + $1375

          In year 2, you only had to legally withhold $Y because that was 100% of the prior year’s taxes even though you owed $Y + $1375! That’s marginally higher than the standard $1000 buffer.

          In reality, this small change probably isn’t even worth considering but I felt the need to flesh it out.

          Thanks for reading!

          1. That’s all great and true. and I quickly dismissed your idea because i had already thought about my entire situation previously and knew what the correct conclusion was. What I forgot to mention is that this hypothetical unfortunately doesn’t apply because even though I missed the fellowship payment twice in 2015, 2015 was also a 27 biweekly paycheck year for me, which negates enough of the “advantage” of missing fellowship payments that the $1000 safe harbor provision is still better for 2016.

            Furthermore, there’s only one year left of this fellowship, so a double missed payments year cannot precede a year with fellowship payments in the future.

  2. Wow this is fantastic, great analysis! I never thought of this before. You talk about avoiding a tax refund so that money can be invested right away. But what if you withhold as little as possible (below what you will owe), invest that money throughout the year, and then when taxes are due you liquidate and pay them? Or is the minimum pretty accurately calculated so that you won’t profit that much?

    1. I briefly mentioned this in the opener:
      “Of course if you wanted to be optimal, you’d actually withhold the minimum amount necessary to avoid under-withholding penalties and invest the extra gained per paycheck immediately.”

      The rules for withholding penalties essentially boil down to meeting 1 of following 3 requirements:
      – You owe less than $1,000 at the end of the year
      – You withheld at least 90% of your current year’s taxes (10% margin for under-withholding)
      – You withheld at least 100% of your prior year’s taxes

      The greater of $1,000 and 10% of your tax burden is an opportunity to get some marginal returns in a safe location, but you have to be very careful to not go over the mark accidentally and owe a penalty.

      Otherwise, if you happen to be in the situation where your prior year taxes were low and the current year will be large, you can legally keep the difference over the course of the year (and put in risk-free high-yield accounts) to generate some extra cash for the year.

  3. Great post, Noah! I’ll send this page to some of my friends.

    I could have certainly been more efficient with dealing with my taxes.
    Similarly to FIBY, I get education credits for attending graduate school so my tax refund the past couple of years have been pretty large. I’ve typically been sending my refund straight into an IRA as soon as I receive it, but as you have stated by example, I miss out on a year of compounding.

    …I’ve been putting off signing up from one of those high-interest savings accounts I keep seeing at DoC, so thanks for that reminder.

    And I have also been trying to pay everything with credit card keeping float just to keep my money in the bank for at least a few weeks longer as well.

    Lastly, do you know of a solid resource to read up on tax deductions/credits? My money situation is simple now, but once I get going with, say, a business, a mortgage, a family, I’d like to know ahead of time of what I could potentially be using as a deduction and what credits I would be qualified for.

    1. Hey Patrick, thanks for reading and sharing!

      I’ve been dragging my feet on getting my full emergency fund into the higher yielding accounts as well, but hope to get on that soon. Paying for everything with credit cards has a TON on advantages so long as you can spend responsibly and pay everything in full. Floating a little cash is on the smaller end of those benefits, but it all adds up!

      I really like using TaxCaster to see at a glance what different deductions are available and play around with different tax scenarios:
      https://turbotax.intuit.com/tax-tools/calculators/taxcaster/

      There’s really no substitute for reading through the IRS documentation if you really want to understand all the different options and plan on filing yourself. This page contains pretty much all the business parts, but feel free to skip sections that don’t apply to your situation:
      https://www.irs.gov/publications/p535/index.html

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