It is one of life's conundrums: If we hate paying taxes, then why do we consistently overpay them, collectively lending Uncle Sam some $300 billion year after year—interest free?
This year, as in previous ones, about 75% of individual taxpayers will receive federal income-tax refunds, with the average refund totaling around $3,000. From a purely economic standpoint, this makes no sense.
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"All a tax refund is, is the government saying to you, 'You've overpaid and here's your change,' " explains Charles Enis, an accounting professor at Penn State University.
The rational thing to do, he says, is to pay just enough taxes throughout the year—via withholding and quarterly estimated payments—to avoid owing a penalty at tax time, and then pay any balance due when you file your return. (The minimum required payment is typically the lesser of 90% of the current year's tax or 100% of the preceding year's tax.) That way, you get an interest-free loan from Uncle Sam instead of Uncle Sam getting an interest-free loan from you.
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But that is not what most of us do. Why not?
One possibility is that we are indeed acting rationally because, with interest rates so low, there's not much opportunity cost to parking some money with the government for a while; it wouldn't have earned any interest to speak of anyway. History shows, however, that we overpay our taxes in both high interest rate environments and low ones.
Another theory is that we find it too confusing or difficult to "zero out" our tax bills by, for example, decreasing the amount we have withheld from our paychecks. But at least one study has shown that even when taxpayers believe they could adjust their withholding relatively easily, they are still hesitant to do so.
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No, it turns out we may actually prefer getting tax refunds. Why? Because they pay emotional dividends.
For one thing, they free us from worry and uncertainty, according to Donna Bobek Schmitt of the University of Central Florida, who has studied the issue. It is never pleasant to have to write a check at tax time, but it is especially unpleasant if the bill is unexpected or unexpectedly large—and even more so if we don't have the cash to pay it. So, to avoid any unpleasant surprises, we err on the side of caution and overpay throughout the year, engaging in a form of forced savings.
Apparently, we don't trust ourselves to set aside money in advance to pay our taxes—with good reason. In a survey for Capital One Financial, only one-quarter of respondents who owe taxes this year had set aside cash specifically to cover the cost.
Then there is the rush we feel from getting a refund, an experience akin to putting on your spring jacket for the first time in a year and finding a $20 bill in the pocket. We frame it as income. A windfall. (Same goes for owing less tax than expected; we frame it as a gain.)
In fact, research by Mr. Enis shows taxpayers are so addicted to this adrenaline rush that those who discover during tax filing season that their refunds will be smaller than hoped (or their tax bills higher) are more likely to open traditional, tax-deductible IRAs or add to existing ones to goose their refunds (or lower their tax bills). Is it any wonder why most IRA contributions are made between Jan. 1 and April 15?
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And what of taxpayers whose refunds end up being larger than expected? They are more likely to open savings accounts or certificates of deposit or to buy U.S. savings bonds, according to an ongoing study of low- to moderate-income taxpayers by J. Michael Collins and Nilton Porto at the University of Wisconsin.
No matter what their size, refunds clearly pay big dividends in the way of spending enjoyment. It seems we view money differently if it comes in a big chunk like a tax refund than if it is dribbled out in smaller amounts, as is the case when you decrease your withholding to give yourself more take-home pay each week.
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According to Ms. Schmitt, we enjoy getting a tax refund more than having the extra money in our paychecks because we are more likely to spend the refund on a vacation or a new TV (Yay!) but more likely to use the extra money each week to pay bills (BOR-ing.).
What will you do with your tax refund this year? Email me your plans and I'll share them, along with some suggestions, in my next column.