How Much Is Your Tax Refund Costing You?

Every year, without fail, I usually have a friend who is excited about his or her super sized tax refund.  Typically at this point I'll take some time to explain to them the reason why the government actually owes them a refund, because they overpaid their taxes.  That $3,000 refund you're so excited about is actually $250.00 a month in over paid taxes.

You guys know I like to take the time to express these problems so let's take a look at your opportunity costs in this particular scenario.  Instead of giving the government an interest free loan to the tune of $250.00 per month what would happen if you invested that money on a monthly basis growing in an account at 8%.

If you haven't guessed yet, this is a future value of an annuity problem, for those of you who don't remember the formula here it is again:

 In this case our periodic payment is $250.00, the interest rate is .66% (8% / 12), and the number of periods is 12.  Plugging these numbers into my trusty HP12C financial calculator gives us a future value answer of $3,111.00.

Look at that, you've given up $111.00 in forgone interest by giving the government a $250 interest free loan on a monthly basis.  But wait, there's more!  How many times do you actually get your refund in January of the next tax year.  Usually, most people procrastinate when it comes to filing so they file on April 14th and get their tax return sometime in May.

Let's assume my friend receives his return on May fourth and we grow the $3,111 dollars by another four months at .66% (8% / 12):

$3,111(1 + .0066)^4 = $3,193.00

Technically, my friend forfeited $193.00 in growth.  Which brings me to my next point, how exactly do you prevent yourself from overpaying your taxes?  Check with your HR department next time you are at work and ask them if they can give you a blank W-4 so you can raise your exemptions.  You'll want to consult with your accountant in order to make sure that you don't raise your exemptions to a point where you actually underpay the amount of taxes you owe and end up owing the IRS money.

Obviously, if you do raise your exemptions you won't receive an outsized return the beginning of the next year but you will notice that your paycheck will be a little larger than your used to.  Just make sure you actually save the money and don't increase your lifestyle expenses otherwise it would defeat the purpose of increasing your exemptions in the first place.

Benjamin Franklin once said, "In this world nothing can be said to be certain, except death and taxes".  Wise words, but there is nothing wrong with doing everything legally in your power to pay the least amount of taxes you possible.