Some Tax Day Advice

Suppose I make you an offer: either I can loan you $1,000 for a year, interest free; or you can loan me $1,000 for a year on the same terms. If you loan me the money, I promise that my credit is as good as the government's. Which deal would you take?

The answer seems obvious, yet millions of people choose otherwise when it comes to income taxes. According to Kiplinger, 78% of taxpayers got an average refund of $2,753 in 2009. They could, by changing their claimed exemptions on their W-4, have arranged things so that they got no refund, or even paid a little. And by doing so, they would have had nearly $230 per month in additional take-home pay for the entire year of 2008.

In the grand scheme of things, timing this money to come earlier (in your paycheck) instead of later (in your refund) doesn't make a huge difference. If you can earn 5% on your money - about what you'd get from a decent bond fund - then the average taxpayer is giving up no more than $100 in lost income. You can push this a bit, though. You don't have to shoot for a zero tax bill on April 15. Current tax law (and please double-check this with a real tax lawyer or accountant before you try this) says that you owe no penalty if you owe no more than the greater of $1,000 or 10% of your total tax bill. So if your bill is $10,000 and you currently get an average refund of $2,750, you can actually reduce your withholding by $3,750 throughout the year, and then pay $1,000 on April 15. That maximizes your interest-free loan potential.

When I bring this up with people who get refunds (and I'm going to a tax-refund party on Saturday, so I'll be sure to gather more anecdotes then), the most common reason people don't follow this strategy is that they think they'll just foolishly spend the extra paycheck cash instead of whatever wise thing they think they'll do with the refund windfall. But that "wise thing" is often something like paying off credit card debt. If they put their extra take-home pay to a high-interest credit card and didn't wait for the windfall, and their interest rate is 20% or more (as many are), then we're talking about maybe $400 per year in unnecessary interest fees. That's real money.

As I wrote the above about people fearing they would spend their money foolishly, I couldn't help but think this described some deep malady in modern America. We do fear we'll spend, and invest, our money foolishly. This is partly because modern life is very complicated. Even professional financial analysts miss things. How can a regular person hope to stay current with all the various tax deductions, investment strategies, credit card deals, sales, rebates, and on and on and on, that a totally with-it person might take advantage of? It's impossible. A rational response might be to just worry about the big stuff and keep one's ears open. But I think many people just give up in the face of overwhelming complexity and live in the moment.

Added to this is the fact that our reliance on regulations to minimize the caveat emptor aspect of capitalism leads (some) people to be less careful than they should be. After all, Uncle Sam is watching, right?

And speaking of Uncle Sam: if people really do fear they'll handle their own money foolishly, doesn't that reduce their resistance to being taxed more heavily? The government - supposedly - is doing something responsible with your tax dollars. We may not trust the government much, but if we trust ourselves even less, to whom else can we turn? It's just more evidence that our nation is losing - has lost? - its tradition of self-reliant individualism.