Here are three positive facts about tax season: most people get refunds, those refunds are often sizable, and Americans are overwhelmingly responsible with that money. According to the IRS, nearly three-quarters of all 2012 income tax returns resulted in a refund. The average income tax refund in 2012 was around $2,800. And in recent years, over 80 percent of Americans have said they intended to put that money toward paying down debt or savings.
More money, more financial responsibility, and less debt all sound like good things. But dig a little deeper, and this all looks like very bad news. Taxpayers—and particularly Americans with debt—who receive hefty refunds may be acting well against their best interests.
That's because tax refunds are not really the bonus money that they can seem to be. Receiving a refund simply means that a taxpayer has overpaid money to the government. That's often because on their W-4—the form with all of the "withholding" lines that everyone fills out when they start a new job—they've instructed the government to take too much from their paychecks. The government keeps that money and gives it back at refund time. For this reason, experts will often refer to tax refunds as "interest-free loans to the federal government."
One financial expert says that though people have their reasons for wanting a big refund, she is deeply concerned about debt-ridden Americans who cheer their annual windfall from the IRS.
"They're afraid that if they have less taken out [of their paychecks], they'll have more money each month they'll just spend it and they'll never get rid of their debt," says Kit Yarrow, a professor in psychology and marketing at Golden Gate University. "I look at that and I think this person is never going to get ahead financially."
Of course, some people do not consciously elect to get a larger refund; rather, when they fill out that W-4, they do it quickly and may indicate that more should be withheld than necessary, she says.
"The concept of taxes in general really is considered a chore. It brings up negative feelings, so people avoid spending time on it," she says.
Still, there is a certain amount of logic at work for those who do choose to let Uncle Sam keep a little extra. Many people say it forces them to spend more responsibly, says Yarrow. With no access to the money throughout the year, taxpayers don't spend it at the bar or the mall, and instead put it toward their MasterCard or student debt come tax season.
But even if it makes sense psychologically, Yarrow decries this decision as deeply irrational. According to her math, some taxpayers are in fact missing out on hundreds of dollars. She takes a theoretical American who receives the average, $2,800 refund but also has $2,800 on a credit card. If that person adjusted her withholding, she would receive $235 extra per month, which could go a long way toward eradicating her debt.
"They would have that entire thing paid off in 10 months and only pay $250 in interest, whereas if they wait until the end of the year and pay it off, they'd pay $500 in interest. So they've just blown $250," says Yarrow.
By the numbers, plenty of Americans may fall victim to this problem. According to a recent survey from Bankrate.com, nearly one in four Americans has more credit card debt than they have in their savings account or emergency fund.
It's not just a question of debt, however. If Americans received more money each paycheck and put it into savings accounts or a higher-yield investments, it would mean not only money saved but new money created.
However, it may not be true that receiving that extra money every paycheck really would leave more Americans better off. A 2008 study found that if people received their refunds monthly rather than annually, it led to higher consumer spending. Annual refunds, meanwhile, were more likely to be saved.
While the study pertained to refunds and not larger paychecks, the results may still indicate that many taxpayers' instincts are correct: that absent a refund, they really would spend the money if it were doled out in smaller increments. Which may signal that, when it comes to tax refunds, it's possible to be both rational and irrational at the same time.