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Why No Refund Is Better for Taxpayers

By correcting excessive withholding, taxpayers may be able to avoid credit card debt and refund splurging, and allocate more to retirement accounts throughout the year, says HelloWallet's Aron Szapiro.

Note: This video is part of Morningstar's February 2016 Tax Relief Week special report.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. A large percentage of taxpayers receive refunds on their tax returns. Joining me to discuss where that money goes is Aron Szapiro--he is a policy and finance expert with HelloWallet, which is part of Morningstar.

Aron, thank you so much for being here.

Aron Szapiro: Thanks so much for having me.

Benz: Aron, let's discuss just the numbers when you look at 2015--the percentage of taxpayers who got a refund on their tax return and also what those refunds tended to look like in terms of dollar amounts.

Szapiro: So, about four in five taxpayers get a refund, and the average refund is a little bit more than $3,000. So, we are talking about a lot of people getting a pretty good chunk of change every spring when they file their taxes.

Benz: HelloWallet took a look at what people who received refunds did with that money. Let's talk about how you are able to get your hands on some data that indicates what people did with the money that they received.

Szapiro: So, our users put it in their financial accounts--credit cards, checking accounts, this kind of thing. And when they used our budgeting tools--anonymously, of course--we are able to look at our users and how they spend their money. Tax refunds have a unique identifier, so we can identify when somebody gets their tax refund from the IRS, and then we can look at how they spent their money in the months leading up to the tax refund and the months afterward.

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Benz: There were really three categories that you looked at. One is that people use the money to pay down debt or maybe pay bills that they want to be current on. They could save the money or they could spend it. How did your users tend to deploy those windfalls?

Szapiro: Only about a third of users tend to save the money. The other ones spend it. About 25% of users use it to pay down credit card bills, and those payments were quite high. Among users who used the money for credit cards, we saw average credit card payments go up $2,000 in the month after they got their tax refunds. And the spending tended to run the gamut. Some people used it for single big-ticket purchases, and a lot of people used it on things like dining out or other kinds of consumer nondurable purchases.

Benz: So, you look at the motivating forces behind these behaviors. Let's look at the spending and why you tended to see people spend even though it looked like, based on your data, that they had the wherewithal to have made those expenditures even without the tax refund.

Szapiro: Yes, that's one of the really interesting things because we can see how much money people have in their savings and checking accounts. We can see that a lot of our users are not what we call "liquidity constrained." They could have made a large purchase prior to getting their refunds. But it seems like the refunds give people license to spend more than they otherwise would. I guess people look at it as free money or fun money. And in fact, we saw--at least in our data--that the bigger the refund, the more likely it was to get spent. So, that was a pretty interesting finding for us.

Benz: Now, the decision to use the refund to retire debt--say if someone has credit card debt--that's not necessarily an irrational choice, right? That may, in fact, be the household's best use of funds at a given point in time.

Szapiro: Absolutely. If somebody has credit card debt, if they can take a chunk out of it, that's a guaranteed return of whatever the credit card interest rate is. It's likely to be the best thing they can do with the money. But it does raise a question. These refunds only exist because people are overwithholding; they are sending more to Uncle Sam every paycheck than they need to and then they are getting it back as a lump sum. So, for some of those households, rather than struggling to make ends meet and putting extra money on their credit card, they would probably be better off keeping more of their money as they earn it so that they don't have to be in this cycle of building up credit card debt and paying it back with that interest.

Benz: So, this issue of overwithholding: Is it simply that people don't really necessarily have the tools they need to make good decisions about withholding amounts?

Szapiro: I think that's probably part of it. Taxes are pretty complicated, and it's a little difficult to figure out exactly how you should fill out your withholding information. Some of it's just inertia and drift. So, somebody starts a job, they fill out their paperwork correctly, and the withholding is more or less what it should be; then their life changes, and they don't adjust the withholding amount. So, for example, if somebody gets married, buys a house, or has children, those things can all reduce your tax burden. If you're not updating the withholding information, you are going to end up getting bigger and bigger refunds.

Benz: One of the takeaways from this research is that, by correcting what they're withholding, people can actually save more on an ongoing basis through a 401(k). I think that's one piece of advice that you would give.

Szapiro: Yes, I think this would be a really good source of money for people who are looking to put a little bit more aside in their 401(k). And if you think about it, if you change that withholding and then put that money towards the 401(k), you wouldn't feel any pain in your paycheck. Now, you won't get that big payday every spring where you get to go nuts and spend a bunch of money, but I think that will be a really good way of helping people in a pain-free way to allocate more money to long-term goals. I think it's a place people could look as they are trying to figure out how they can save a little more for retirement.

Benz: Aron, some interesting research here. Thank you so much for being here to share it with us.

Szapiro: Thank you so much for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.