Getting a Tax Refund is Costing Americans Billions

Here's a piece from USA Today on how Americans are getting their biggest tax refunds ever this year and it's costing them a fortune. The details:

• Taxpayers overpaid their federal income taxes by a record 29% in both 2003 and 2004, according to a USA TODAY analysis of Internal Revenue Service data.
• That has pushed refunds above $200 billion a year. Final figures aren't in for the 2005 tax year, but the average refund so far is $2,423, up 4% from last year.
• The fatter refunds are the result of taxpayers withholding nearly twice the traditional safety margin from their paychecks to avoid a year-end tax bill.
• The extra withholding gives the government an interest-free loan worth more than $10 billion a year, equal to about $100 per tax return.

So, it's costing tons of money, but people still do it. Why? Here's part of the reason:

But many people love the forced savings and its reward — the fat refund — no matter how much it costs. "Taxes are so complicated people are just happy to come out ahead on April 15 rather than behind," says Ellen Katz, editor of the Tax Savings Report newsletter.

I've previously written that giving the government an interest-free loan is a bad idea, but for those people who couldn't save any other way, maybe it's not so bad. However, it is a more expensive way to save. Plus, it doesn't really benefit the "saver" if he/she just blows the money when it comes in.

What do you think -- are refunds ok in some situations for some people?

Comments

[Blaine Moore (Run to Win)]

Refunds may be okay in some situations for some people, but not for me. I'm happy with my $100 tax bill every year.

Ideally, I would like to not pay any taxes until february. I know that I am capable of putting the money aside and earning my own interest on it, but Uncle Sam won't let me do it that way. For 99.9% of Americans, I think that that would be a recipe for disaster.

[Anonymous]

Imagine if all of that money were going into 401(k)s instead. Sure, it wouldn't be available as a downpayment on a new car or to fund a vacation. Picture even half of that going into retirement savings. Of course, I suspect I'm preaching to the choir here.

[Ken]

I'm not so sure it's due to people having more withheld. It might have more with peoples taxes being to complicated and being scared that they will get audited. The tax system is unfair and I can't wait until some day (hopefully in my life) that some intelligent individual kicks some ass to make the flat rate a reality...

Having too much tax witheld and getting a refund early next year is not too wise. Many financial articles acknowledge this but almost none are specific enough in explaining how to avoid this situation.

Most people fill out a form at the beginning of the year called a W-4. This form asks you a series of questions and directs you to write a number of "witholding allowances" down based on your answers. The number of witholding allowances determines how much of an employee's paycheck is witheld in taxes. The average worker just answers the questions honestly and writes down the number as they are told. The dirty little secret is that the IRS calculates the numbers in such a way that if a person fills out the form as directed, they are very likely to have too much tax witheld.

The way to get around this problem is to simply claim more witholding allowances than the Form W-4 instructions tell you to. Many think there is a penalty for doing this but that isn't true. The penalty only goes into effect if your total tax payments during the year are less than both 90% of this year's tax and 100% of last year's tax. Your total tax due(after payments and credits) must also be at least $1,000 for a penalty to go into effect.

So my advise to most workers for 2006 is to look at form W-4 and answer the questions as you normally would but add at least one witholding allowance to what you would normally claim. You'll be pleasantly surprised at the extra cash in you paycheck.