This article has been updated for the 2022 & 2023 tax years. As we approach another tax deadline, the IRS has been churning out data on average tax refunds already. The average tax refund in the most recent year was $3,176. That’s a huge infusion of cash landing in the laps of a lot of taxpayers. As contrary as it may seem, however, receiving a tax refund is not a good thing. A tax refund is simply getting your hard-earned money given back to you with 0% interest (actually, a negative return when you factor in inflation erosion). You overpaid your taxes throughout the year and the result was an interest-free loan to Uncle Sam. Your tax refund is you getting your loan back – without any interest.
The result of this false payday is often referred to as “tax refund windfall syndrome” (by me, at least) – where taxpayers are handed a huge check that results in new positive cash flow that they normally don’t have – so their first urge is to go out and spend it on a bunch of stuff that they don’t need. To “treat”, or “reward” their-self as if they were betting house money.
What if those refunds were treated with wise restraint instead? Refunds are cash that was not counted to live on over the previous year, right? So what if 100% of refunds were (appropriately) funneled directly in to personal savings and left there for good? And in putting your tax refund to good use, you were guaranteed a positive ROI.
It’s hard to get an apples-to-apples comparison when the metrics that are reported vary, but some back of the napkin math paints just how massive of an impact this one simple little act of discipline and restraint could have:
- The median U.S. household income recently was at $70,784 (pre-tax).
- The average tax refund for the same year came it an $3,176.
- Take that average refund ($3,176) and divide it by the average household income ($70,784), and you get a refund/income ratio of 4.5% – and higher, if you were to look at income in a post-tax sense (tax refunds are post-tax dollars, of course).
Now, 4.5% does not sound like a lot, until you consider that the average personal savings rate for Americans hit a near historical low of 2.2% (record was 2.1% in July of 2005), it’s a lot.
In other words, American tax refunds are more than 2X as much as annual personal savings, at the moment!
If we assume that those refunds are going anywhere but personal savings, the act of diverting them in to personal savings instead could result in more than a doubling of the personal savings rate, on average. And with 63% of Americans claiming to be living paycheck-to-paycheck, the urgency of saving that money becomes even more clear.
1 check, 1 deposit, double the savings. Your mileage may vary in the results, but the advice stays the same.
- How to Check your Tax Refund Status
- How to Pay your Taxes Online
- The Best & Cheapest Way to Efile
- How to Use the IRS’s New W-4 Form to Balance your Tax Withholding
I’ve taken the approach of claiming 2 exemptions on my W4 (single, no one else can claim me as dependent). The end result is a small return if I even get one at all, but the extra money in my pocket each month is usually devoted to savings, paying down debt, or investments.
It’s better served with me than sitting in the government’s pocket for months!
This is a very upper middle class view of things. It’s my understanding that a significant potion of refunds are due to refundable credits such as the alternative child tax credit and earned income credit. For example, my family of four lives on an AGI of approximately $33k (single income) and even without any federal withholding we get about $5k back at tax time. Now we live pretty well on that amount and could be saving more than the $7k per year we currently save, but I know many people who aren’t as well off as we are and look forward to their refund to get necessary services that they haven’t been able to afford, such as having a tooth pulled that’s been aching for months, or getting a car repaired that’s needed to keep earning a paycheck, new eyeglasses, etc.
I wouldn’t make the assumptions you have obviously made, that refunds are “extra” money that isn’t needed and could have been taken home by adjusting withholding. I see it as money that is sometimes desperately needed, but wasn’t available before.
Sure, there are people out there who use refunds for everyday expenses – I don’t mean to diminish that reality and challenges faced. However, it’s also hard to deny that refunds are often seen as bonus money and used as such versus being saved by a large segment of the population. And the impact, presented by these numbers could be pretty impactful if more restraint was used.
This is a just-in-time reminder for us to save the extra money instead of spending.
Just to share, one good practice of a friend of mine also is to save the salary increase per year. As soon as he receive his increase, he sets up an automated transfer from his personal account to a Cooperative where he is a member. It is a no-brainer investment. Personal savings on the cooperative yields 9%/year on average.
What he does is maintain his lifestyle, avoid shiny objects and save. Right now he has the biggest savings in the cooperative. Really amazed with this guy.
For us, we are good at saving for windfalls. However, if we have bigger paychecks, then we will probably spend more as we “make” more. That’s why I do it this way.
Personally, I have my withholdings tweaked to the point where I either receive a very small amount (very rare) or pay about $100 to State & Fed. Now, I understand that everyone has their own situation and cannot do the same for whatever reason, but regardless I think it would bode well for anyone receiving 1k, 2k, or more on their tax returns to simply redirect it into an IRA. Then, as G.E. points out, you create a savings for yourself and family and you’ll be able to get a tax break next year on the IRA contribution. It’s a win-win.
We have the same plan for any “extra” money that comes our way whether achievement awards, bonuses, or refunds. It all goes to savings. We have our fun money budgeted each month so there is no need for extra to “treat” ourselves. Our treat will be living the way we want sooner rather than later.