It’s that time of year when everyone gets excited for their hoped-for tax refund. But should we really be celebrating?
In 1943, Congress pushed through the Current Tax Payment Act which required taxpayers to stay current on their tax liability. They accomplished this via a new withholding system that applied to earned income (e.g., salary and wages). Prior to that, taxpayers could simply pay this year’s taxes next year. This made the U.S. Treasury Department a creditor to every single taxpayer in the country. As the Federal government needed more revenue to fight World War II, it became necessary to expand the income tax base by taxing more citizens. However, broadening the tax base meant that the quality of the debtors would decline, unless the Treasury developed a better way to collect taxes.
Of course, it wasn’t just the deterioration of the income tax base that prompted Congress to pass the Current Tax Payment Act. The war was creating inflation, which meant that a dollar tomorrow was going to be worth less to the Federal government than a dollar today. It needed the revenue sooner and a withholding system was the perfect way to get that done. That also made it easier for the Federal government to raise taxes in the future, since a small increase in taxes owed every single pay period is easier to bear than a big charge at the end of the year.
Lender or Borrower?
It is extremely unlikely that you will ever pay exactly what you owe in Federal income taxes (unless you owe nothing and pay nothing). Therefore, you only have two options: Pay more than you owe throughout the year or pay less than you owe throughout the year. If you pay more than you owe, then you get a refund at the end of the year. If you pay less than you owe, then you write a check to cover the difference. So would you prefer to owe the government money or do you want to receive a refund?
Lend Money to the Government
Americans are known to spend — it’s one thing we do really well. So some argue that overpaying the Federal government is a method of creating savings. The problem is that if Americans are truly spenders and not savers, then most who receive a tax refund will simply spend it. So the real question is do you prefer to spend your money now or when you receive your refund next February, March, or April? By overpaying income taxes, you are giving the Federal government your money to spend as it will until you file your tax return. At that time, the government will send you a check for what is owed you – with no interest paid to you. In other words, you have given the government a no interest loan. If you’ve ever complained about not receiving interest on your checking account, be aware that the same is true when the government owes you money.
Borrow Money from the Government
If you’re a good saver then this is the route for you. If you can save money and be prepared to send a check to the Federal government in April, then you have flipped the equation and received an interest free loan from the Federal government for the amount of taxes you owe. During times of higher interest rates, you could let that amount sit in a very safe checking account and earn interest, with little to no risk. You have to be careful though. The Federal government (and state governments) recognizes that some individuals will try to minimize what they pay throughout the year so you’re required to pay either 90% of current year taxes or 110% of your previous year’s tax liability. If you don’t satisfy one of those two then the government will charge you an underpayment penalty. With that caution, if you’re able to develop good saving habits, then it’s time to stop lending money to the government and start letting it work for you. And you should probably stop celebrating that tax refund.
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