The Basics

Conventional wisdom says that it is better to optimize withholdings and strive for a net-zero end of year federal return. Preferably a refund. But does that work for everyone filing a tax return? Let’s look at the reasoning.

    The logic is fairly straightforward. By withholding too much money from your paycheck, you are effectively giving the government a tax-free loan. You are better off if you have that money immediately invested rather than waiting to receive a refund. Let me show you how.

    Let’s say, for example, I am withholding $50 a month too much from my tax return. At the end of the year, I would receive a $600 refund from Uncle Sam. Hypothetically I that extra $50 a month and put it into an index fund with an average return of 7%. This is roughly the historical average. After 12 months, I would have around $620.  Twenty bucks is still twenty bucks, but it’s not exactly world-shattering.

    The Brass Tax (Return)

Now it’s time for a reality check. Speaking for myself, if I have an extra $50 a month, it’s likely not going into any sort of investment. It would probably end up going to Amazon for something I’ll only use once and then forget about. This is why conventional wisdom doesn’t work for me. Any extra money I save on my tax return by not giving it to the IRS would be given away to someone else. I just don’t have that much discipline, yet. I am actually more likely to save or invest a portion of a decent refund than make small monthly contributions. 

    There’s one other reason why I’m leery of minimizing my monthly tax withholdings. The risk of not paying enough on my federal tax return. If you’ve ever had to pull out your checkbook on April 15th, you know how stressful that can be. I like to overestimate my expenses for that reason.

    And so based on the above reasoning, I argue that it is actually better to receive a refund rather than minimize my tax withholdings. Are you the type of person who is disciplined enough to follow a strict budget? Do you simply hate the idea of letting the government hold your money for free? Unless you’re one of those, the prospects of getting a nice end of year bonus outweigh the risks of having to write a check or just squandering small monthly gain.

Ultimately you have to do what works best for you, let us know what you decide. If you need to brush up on some additional basics we’ve got more content in our knowledge center!

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