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Change Your Clients’ Thinking on Tax Refunds

Tax refunds aren’t found money, and they should be considered part of investors’ long-term saving strategy.

Sheryl Rowling, 05/05/2016

Tax season is behind us. Many taxpayers are breathing a sigh of relief and already spending their tax refunds. But, are they using their refunds wisely? What constitutes using a refund wisely?

According to Aron Szapiro, Policy and Finance Expert with Morningstar’s HelloWallet: 

> The IRS sent refunds to more than 80 percent of taxpayers in 2015, averaging $2,700 each.

> Only 37 percent of recipients saved their refund checks. The remaining refund recipients paid down debts and made additional purchases.

> Over 80 percent of refund spending occurred within one month of receiving the money.

Before discussing how to use refunds wisely, there is the question of whether getting refunds at all is wise. Refunds occur as a result of withholding (or paying in) more tax than what is actually owed. Although over-withholding can work as a form of forced savings, it is not rewarded with interest. In other words, a refund means that the government was given an interest-free loan. If over-withholding is the only way a taxpayer can save money, it is better than not saving money at all. However, since only 37 percent of refund recipients actually save their over-withholding, tax refunds are not a particularly effective savings strategy. 

If your clients count on using refund money to pay down credit cards or consumer debts, they may be overspending throughout the year. In a study by Agarwal, Souleles, and Liu, (The Reaction of Consumer Spending and Debt to Tax Rebates—Evidence from Consumer Credit Data, 2007) many consumers who used tax rebates in 2001 to pay down credit card debt did, in fact, rebuild their debt in the following months. 

Rather than repeat this cycle each year, taxpayers would be better off lowering their withholding and avoiding credit card debt. According to Szapiro, the average credit card pay down from tax refunds was $2,000. At typical retail interest rates, the taxpayer would save approximately $160 over the year by simply decreasing withholding and using the "extra" money to pay down credit card debt on a monthly basis. 

So, back to the point: How can a tax refund be used wisely? The best way to handle a tax refund is to not have one at all. Absent that, it all comes down to basic financial principles: Live beneath your means and save the rest. If you live beyond your means, you will always be in debt. If you simply live within your means, you will never save and, thus, never be able to retire—or even handle financial emergencies. Put simply, tax refunds should be viewed as money that belongs to long-term savings. 

On the other hand, if you have accumulated consumer debt, it is typically better to pay off non-deductible, high interest rate debt than to add to savings. The key is to not build up more debt after that!

What about spending the refund? Spending on nondurable goods, such as restaurants, travel or clothing, is increasing lifestyle expenses. It will only extend the cycle of overspending. Yet, spending on a long-term asset can actually be a good thing. For example, if you've been saving up for a down payment on a house, a tax refund can help accelerate the process. 

As with any "spend or save" decision, the best financial move is to save. However, most people don't work for the sole purpose of building their balance sheets. Most people want some enjoyment from their labors. It's a fine line between living for today and saving for tomorrow. Therefore, from a practical standpoint, I recommend my clients allocate a small portion for fun and the rest for savings. The next time your clients get a tax refund, have them consider spending 10 percent and saving the rest. Then, lower withholding and set up an automatic deposit to savings.

As opposed to thinking of refunds as "bonus" money, advisors and their clients should treat them as any other financial asset. This means mindfully planning for and optimizing the amounts and ultimate use of tax refunds. Because clients don't always make the financial best decisions without proactive guidance from their advisors, you can use tax season to start financial planning conversations that lead to better long-term outcomes.


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