Financial advisors have long preached that receiving a tax refund simply means that the taxpayer has provided an interest-free loan to the government, and that you could instead be earning 2.25% on a 12-month T-bill investment.  Yet 65% of U.S. taxpayers say that they would rather have a lump sum refund than keep more money each pay period during the year (according to a JP Morgan Chase Bank study).  The Federal Reserve Board states that 40% of American households cannot accumulate $400 in a financial emergency, and the average $3,600 in tax refunds represent 2.5% of the U.S. GDP. The refunds are an average of six weeks of pay.

The rise of do-it-yourself tax preparation software means that fewer people are connecting with a tax professional or financial advisor, who otherwise may be able to suggest changes to the W-4 withholding forms or educate people on the advantages of alternative savings programs.

How can Americans reduce their use of tax refunds as their de facto savings plan?

John Pitts, a former Deputy Assistant Director for Intergovernmental Affairs at the Consumer Financial Protection Bureau has some ideas from his April 2019 commentary found here:

Pitts suggests a few ways to reduce using tax refunds as lump sum savings plans, which include:

  1. Spare change apps which round up to the dollar on purchases and places the difference in an interest-bearing account or investment.
  2. Employers could withhold after-tax contributions to a money market account.
  3. Congress could require the IRS to change the W-4 to allow withholding into a Treasury Inflation-Protected Security, which earns interest on the funds throughout the year.

Many people use high interest loans and credit cards to make ends meet during the year, and then receive a large lump sum tax refund in February. This refund is then used to purchase delayed needs items, such as clothing or home repairs. This exacerbates the problem by combining an interest-free loan to the government while paying high interest on short-term borrowing. Because of changes to the tax code and the IRS use of more accurate W-4 withholding forms, wage earning Americans can expect to see smaller tax refunds in 2020 and beyond. If we are unaware of these changes and are not seeking alternative savings plans, many people will find themselves without the large tax refunds upon which they’ve come to rely.