Why I hate income-tax refunds

By Jeff Schnepper

Refunds: They're wrong!

It's hard to get that through to my clients. But refunds are bad.

Sure, it's exciting to get a check from the Internal Revenue Service. Well, actually, it's from the Treasury, but you know what I mean. That misses the point, however.

It's not like you're gaining anything. That money was always yours. The feds are just giving it back. And that's the point.

When you get a refund, what that really means is that you've given the federal government an interest-free loan. You're just getting your money back.

In fiscal 2005, 106.3 million Americans got tax-refund checks averaging $2,141. That's about the same as the IRS paid out in fiscal 2004. Either way, when you do the math, that's a whole lot of interest-free dollars.

An offer you can't refuse?

People just don't learn. They want that check from the government. But I can give you the same deal.

I hereby offer to allow anybody reading this to send me money. I'll take cash, checks, money orders, even food stamps. Send me as much as you want. And I promise -- on my word as MSN Money's tax expert -- that I'll send it back to you on April 15, without interest.

It sounds silly when you put it that way, doesn't it? But it's no different than getting a tax refund from the IRS.

Some people argue that refunds are a great way to save money. If they never see the dollars in their checks, it's easier to put aside money for, say, that big-screen plasma TV they've been drooling over.

Open your eyes, financial fool! That's what payroll savings deductions are designed to do. Buy savings bonds or, better yet, increase your retirement-plan contributions. Or just put an extra $50 per paycheck into a money-market fund.

Here's what I'll do. I'll up the ante on my original deal. Not only will I give you your money back, but I'll add a whopping 2% to your original contribution. That's twice what the money-market funds were paying not too long ago. You can't beat that kind of deal.

Aim to withhold just enough

If I can't entice you with my "deal of the decade," what should you do?

Aim for the safe harbors. That's the minimum amount you have to pay during the year to avoid any interest and penalties. There's no interest or penalty if any of the following apply when you file your return on April 15:

• You owe less than $1,000.

• You've paid in at least 90% of your 2007 liability.

• You've paid in at least 100% of your prior year's total tax. On your 2006 return, that was Line 63. Go check it as you begin planning your 2007 return.

If your adjusted gross income (Line 37 on your Form 1040 for 2006) was more than $150,000, then you need to pay 110% of your total tax, rather than 100%. So if my 2006 adjusted gross income was $160,000 and my total tax was $10,000, I'd need to pay 110% of that, or $11,000, during 2006 to hit that safe harbor. If I do that, there's no interest or penalty to pay, regardless of how much I owe on April 15, 2008.

If you're paying through withholdings, they are deemed to be paid evenly during the year, regardless of when they are remitted. I have some clients who have nothing withheld during the first 10 months and then meet their safe harbors with November and December withholdings.

If you're making estimated payments, they need be equal or, if your income varies substantially during the year, proportional to the income earned during each quarter. So on a simplistic basis, if I have $100,000 in income earned and $40,000 was earned in the first quarter, I'd need 40% of my tax paid in during that quarter. Technically, it's called the annualized income installment method, and it's a bit more complicated than my simplistic example.

See Form 2210 for the required computations. Get it from the IRS Web site.

If you expect to owe more April 15, it would be prudent to put those dollars into a money-market fund until needed. At least that way, as opposed to increasing your payments to the IRS, you'll get the interest. Just make sure you hit one of the safe harbors.

And don't get any more big refunds. Refunds are BAD! BAD! BAD! Trust me on this.

Updated Feb. 12, 2008