This probably gets said to everyone every year, but I feel I need to repeat it: if you get back a big tax refund, it’s not like you’ve outsmarted The Man, or like you’ve gotten a big windfall; it’s just that you paid the government more throughout the year than you needed to, and they’re giving you back what you overpaid.
I really think many people don’t understand what they’re doing when they file their taxes. They’re computing on the one hand how much they should have paid during the previous year, and on the other hand how much they actually *did* pay. Subtract what you did pay from what you were supposed to pay. If the result is a number greater than zero, then you underpaid during the year, and you need to pay to make up the difference; if it’s less than zero, you overpaid, and the IRS owes you back some of your own money.
When you underpay throughout the year, you can take the extra money from every paycheck and put it in a bank account and earn interest, or you can invest it and (if you’re lucky) earn a positive return. Whereas if you overpay, the government doesn’t pay you interest at the end of the year. So by overpaying throughout the year and receiving a refund at the end of the year, you’ve given the Federal government an interest-free loan throughout the year.
The optimal strategy, then, is to do two things:
1. Estimate, early in the year, roughly how much you’re going to owe in taxes.
2. Underpay throughout the year by just enough that the IRS never gets mad.
Actually, 2. isn’t quite right. It’s okay to get them mad, because when they get mad they just charge you money. If you know your tax situation well enough, you can have them charge you just enough money that you still end up ahead. Suppose they charge you $1.05 for every dollar you underpaid. Well, if you can get a 6% return on your money by investing it rather than paying it to the IRS, you should just invest that money, earn 6%, then pay the 5% penalty. You’ll still end up ahead.
But presumably they don’t just charge you some fixed low rate of interest for every dollar by which you underpaid throughout the year. I don’t know, but I would imagine you pass some threshold where your underpayment makes them *really* unhappy (we might say that their response is “nonlinear”). So the optimal strategy would be to underpay such that the marginal dollar of underpayment is just offset by a marginal dollar of fines from the IRS.
I realize this takes all the fun out of why people like tax refunds. They like seeing a nice big check. And I think a lot of people don’t believe they have the self-control to set aside a few dollars with every paycheck; they believe they could handle a windfall better. If that’s how you feel, then go you. Empirically, I wonder if it’s true that people can handle a windfall in their taxes any better than they can handle a small regular payment.
Generally speaking, I don’t understand why people find taxes so vexing. For most of us, it’s simple:
1. Add up all the money you made during the year.
2. Subtract exemptions for yourself and your dependents.
3. Subtract deductions for your house and charitable contributions.
4. Use the tax tables to figure out what you owe.
Some people do have it hard. Small-business owners, I would wager, will find this particularly tricky. If you have lots of complicated financial assets, it’s probably annoying. I’d like to look it up empirically, but here’s a quick observation: most people don’t itemize their deductions. If you take that as a measure of how complicated most people’s returns are, you have your answer: most people’s returns aren’t complicated.
And if the pain of filing your taxes is that you’re sending money to the IRS, you can eliminate this pain by just setting up your withholdings properly throughout the year. Set it up so that you owe nothing, and are owed nothing, at the end of the year. If you’re like 2/3 of Americans, this isn’t hard: you’re not even going to be itemizing the deduction for the home you own.
Indeed, most Americans would be just fine letting the IRS handle their taxes for them, if we had such a thing; we’d be more likely to have such a thing if tax preparers weren’t lobbying against it. Your employer would submit your salary to the IRS; your bank would submit your interest income; your mortgage company would submit any interest payments you made; the IRS would tell you what you owe, and you’d be done with it.
For most people, though, I just don’t see what the big deal is.