Asymmetrical Information - Megan McArdle

04.14.13

Happy Tax Day. Now Stop Making Interest-Free Loans to the U.S. Government.

Wipe that smile off your face. That big tax refund is bad news.

As I write this, April 15 looms. Not for me, mind you—we took our taxes to the accountant weeks ago. But for millions of Americans who will be driving madly to the post office at the last possible minute, dropping their returns in the slot, and hoping a sizable tax refund. Many of you have been looking forward to that refund for weeks, planning all the great stuff you’re going to do with it.

This is all wrong.

No, not the last-minuteness of it all. Oh, sure, you should probably do your tax returns a few days early, so that you won't have the worry of traffic and fender-benders in the post-office parking lot. But that’s a personal choice I won’t hector you about. If you don’t have anything better to do with your Monday evening, who am I to judge?

The tax refund, on the other hand, I judge. That, my friend, was an enormous mistake.  

A tax refund is not free money you get from the government. It’s free money you gave to the government—by overpaying your taxes all year. You think the interest rate on your savings account is paltry? At least it's not zero, which is the amount Uncle Sam pays you for your yearlong interest free loan. (If you underpay the government, on the other hand, they charge you not only interest, but also penalties.)

You’re getting a refund because you allowed your job to overwithhold. Sometimes that’s unavoidable—we’re getting a refund this year because I spent six months on unpaid book leave, which threw all of my withholding off. And people who qualify for the earned income-tax credit pretty much have to take it in an annual lump sum. But that’s no excuse for the rest of you. If you have a steady job with a regular salary, you shouldn’t be getting more than a token amount back in April.

I know what you’re going to say: you like getting the surprise check. It helps you to save. If you were getting that money in small increments every two weeks, rather than once a year, it would probably have trickled away on beer and Skittles. And fair enough.

Luckily, I can tell you how to effectively replicate the tax refund experience, except in an interest-bearing account. First, go to your bank and open up a new savings account, one that isn’t linked to your current checking or savings. Second, go to human resources or payroll and change your withholding. And third, while you're standing in human resources, ask the nice person there for a form to change your direct deposit. Set it up so that a fixed amount from every check goes into that new savings account. Depending on whether your pay cycle is monthly, bimonthly, or biweekly, that amount should be, respectively, 1/12th, 1/24th, or 1/26th of the amount you’d like to have at the end of the year.

I know, I know--what a pain! But you only have to do it once. And at the end of the year, every year, you'll have a nice big sum in your account. Best of all, it will have been earning interest. A sadly tiny amount of interest, to be sure. But whatever the amount, over a couple of years it will more than repay the hour that you spent setting all this up.

Even better, if you have an emergency in the middle of the year, you’ll be able to tap your savings. Try going down to the IRS and getting them to advance you a thousand dollars because the cat broke its leg.  

Of course, you don't want to be underwithheld either—pay too little in taxes, and you’ll trigger the aforementioned interest and penalties. So start by changing your withholding just a little bit. If you’re still getting money back next year, you can raise your deductions a little more, until you have gotten to a point where you will “neither a borrower nor a lender be.”

Just make sure you’re moving in the right direction. Interest-free loans are for children, siblings, and the occasional down-on-his-luck drifter who just needs someone to believe in him again, not for the U.S. government. There are crazy Asian central banks that are willing to lend to our government at negative real interest rates. You should let them be the ones to give Uncle Sam free money. Keep your own money in the bank, where it belongs.