It’s tax season, and millions of Americans are looking forward to the seemingly sweet reward that sometimes follows the grueling task of filling out the 1040 tax form and its many cousins: a big, fat tax refund. Many see these refunds as pleasant windfalls, free money they can spend on something fun without feeling guilty or frivolous. Unfortunately, this popular view isn’t quite right. Tax refunds aren’t free money from Uncle Sam. Rather, they’re a return of your money—money you lent Uncle Sam, who didn’t pay you interest.
We often say opportunity cost is money lost, and this is a perfect example. Depending on what you would have done with those extra tax payments if the IRS hadn’t unnecessarily withheld them, you could have had quite a bit more in your pocket when all was said and done. Say you get a refund of $1,200. What if, instead of needlessly giving the extra $100 to the government each month, you were able to invest it? If you simply invested $100 in the global stock market on the last day of every month in 2016, using MSCI World Index returns (including dividends), the $1,200 you invested would have been worth $1,348.27 by March 15, 2017.i Withholding too much cost you nearly $150 in missed growth. Call it a stealth tax. That’s one year. Now consider every year you got a big refund and all the cumulative, compounded stealth tax you unwittingly paid.
A common counterpoint is, “Yeah, but if I didn’t withhold more than needed, I’d probably end up with a big bill in April, and that isn’t good either!” And true enough, being hit with a sudden, and potentially large, unexpected payment isn’t pleasant. Folks often have to tighten the purse strings in April in order to make sure Uncle Sam gets his cut. But owing money with your tax returns isn’t the only alternative to a refund: Breaking even (or close to it) is also an option. We’re happiest when TurboTax or our CPAs tell us we owe a dollar—it means we planned right and didn’t miss an opportunity to save or invest more of our income. That’s when we feel like we “win” at taxes.
If you’re regularly hit with big bills or receiving big refunds, talk to your CPA, and have them see if it makes sense to update your W-4. Tell them you’d prefer to make use of the funds you’ve been lending to the government for free all these years. Heck, maybe this is even a way you could boost your 401(k) or retirement funding! Revising your estimates of itemized deductions and credits you plan to take could bring your withholdings much closer to your final tax bill, reducing headaches in April and opportunity cost all year long.
iSource: FactSet, as of 03/16/2017. MSCI World Index return with net dividends, 01/31/2016 - 03/15/2017. Assumes $100 invested in the MSCI World Index on the last day of each month from January 2016 - December 2016, with no withdrawals, and remaining invested in 2017.