The Hidden Danger of Large Tax Refunds


It is no secret that many taxpayers use payroll tax withholding as a method of forced savings.  Each spring they receive a large refund on their tax return, using the proceeds to fund a vacation, a car down payment, or other large purchase or savings goals.  In doing so, they put themselves at more risk than they realize. You have heard the usual arguments against overpaying on your tax return to receive a large refund.  There is the opportunity cost, which is the forgone interest you could have earned by saving or investing those funds during the year.  Given near zero interest rates on traditional banking products, this loss is small.  Most who rely on the large refund technique would argue that the inaccessibility of these funds promotes savings when self-control is not enough.

If there were a substantial risk your refund could be delayed by months or even years, would you change your mind about this strategy?  The IRS reports that tax fraud related to stolen identities is on the rise.  In one common scam, a thief will file a false return under your social security number and claim a large refund.  Once you attempt to file your actual return, the IRS system rejects your claim.

In most tax fraud cases, it takes time to work through the layers of IRS taxpayer bureaucracy and advocacy to substantiate your claim.  This process is slow and it can take up to 18 months or more to get your refund.  It is not hard to imagine a scenario where a taxpayer who relies on this large annual tax refund is left in a pinch when her refund is delayed.  You may be the one stuck with penalties or interest when your delayed refund results in missed payment deadlines for your real estate taxes, credit card bill or other bill you planned to pay with the refund.

This year I encourage you to avoid over-withholding to gain a large refund.  Instead, adjust your withholding to a lower level sufficient to pay your expected tax bill.  Then, with your larger net paycheck, focus on ways to save out of sight, out of mind.  In today’s digital banking era, direct deposits and automatic transfers from each paycheck can easily be setup to force savings.