Tax Day 2012: Finding a Better Use for That Tax Refund

NEW YORK (MainStreet) -- It’s Tax Day, time for the annual scolding about paying too much.

As The Wall Street Journal put it in an e-mail to subscribers: “Getting a Big Tax Refund Means You're Doing It Wrong.”

In other words, a refund means you gave Uncle Sam an interest-free loan. INTEREST FREE!

But these days, with interest rates so low, who cares?  The typical refund is around $3,000, representing an excess tax withholding of about $58 a week. If you had instead received that money and put it into a savings account at today’s average yield of 0.108%, you’d have earned a princely $17.60 over 52 weeks, enough for a dinner for two at Taco Bell.

It’s small change, but that doesn’t mean over-payment is a non-issue. If you replace the word “interest” with the word “return,” and take a sensible long-term investment view, the results are more compelling.

Suppose, you started now with an investment of $58 a week, increased the sum each year to keep up with inflation, and earned, say, 6% in a mixture of stocks and bonds. You’d have about $140,000 after 20 years, perhaps enough to retire a few years earlier.

Surveys show that many taxpayers typically see their refund as a windfall to be spent – a source of “free money.” Everyone knows that’s not really what it is, but the idea is irresistible, like a second Christmas arriving in April.

Often there are competing uses for this cash, like paying down high-interest credit card debt, or beefing up a rainy-day fund. But self-control is tough when you’re holding a fat government check.

So what’s the best move? It’s probably to do what the town scolds have been saying all along: file a new W-4 form to reduce your withholdings so you’ll never face the temptation to spend. Instead, each paycheck would be a bit larger.

At the same time, you could increase your contributions to your 401(k), or set up an automatic monthly investment with your broker or mutual fund company, having the money automatically withdrawn from your checking account. That way, this $58 a week, or whatever it is, would be put to a valuable purpose. And since you’re not used to seeing that money in your paycheck, the investment would seem painless.

This would work best if your money were automatically deposited in your checking account.

Of course, if you had a big balance due on your tax return, you can use the W-4 to increase your withholding instead of reducing it to avoid a repeat next year. By paying the proper amount of tax week by week, you’ll avoid the penalty and interest charges that can result from paying too little.

Either way, start by comparing your finances for last year with the income and expenses you’re likely to have this year, keeping an eye out for special situations that may have caused you to pay too little or too much. A big capital gain on an investment can produce a tax bill in April, for example, just as a capital loss can result in a refund.

But if special situations were not at play, and your tax situation will be much the same this year as last, it really can pay to get your employer to withhold the proper amount – neither too much nor too little. Even if the lost interest on a loan to Uncle Sam is incidental, the long-term cost of frittering away annual refunds may be too high to ignore.