Bigger Paycheck or Bigger Tax Refund — Which Should You Pick?

By Emily Guy Birken on 31 March 2015 2 comments

One of the earliest money lessons that I remember learning from my financial planner father was the correct protocol for tax refunds: The ideal situation is to receive a modest refund of $500 or less. (See also: 12 Smart Ways to Spend $500)

This advice struck a chord because it made perfect sense. Why give Uncle Sam an interest-free loan every year just to feel the excitement of getting your own money back each spring? I agreed with my father that it's a far better idea to keep the money in your paycheck, invest it throughout the year, and let it work for you.

Which prompts the question — why do nearly 80% of taxpayers get a refund each year, at an average size of $2,800?

What financial planning advice often overlooks is the importance of psychology in money matters. For individuals like me, who can think of nothing more fun to do on a Saturday night than balance my checkbook, getting a modest refund really is the ideal situation for managing money. But for many taxpayers, getting a big refund can be the best path to good financial decisions.

How do you know if you would be better off with a big refund or a modest one? Learn more about the psychological quirks could influence your refund decisions.

The Denomination Effect

The denomination effect is a phenomenon wherein people are less likely to spend big bills compared to small ones. If you have ever held onto a $50 or a $100 bill for several weeks, but don't blink an eye at spending the same amount in tens, fives, and singles, then you have experienced this effect.

When it comes to taxes, the denomination effect is why you might not even notice an extra sixty bucks in your weekly paycheck — but turn that into a $3000 refund check at the end of the year, and suddenly it's a large enough amount of money that you feel the need to do something intelligent with it.

If you struggle with keeping track of smaller amounts of money, but feel perfectly comfortable making good decisions with a large check, then it might make sense for you aim for a large refund that you invest. It will be a better use of that three grand than frittering away your extra $60 a week. (See also: 50 Smart Things to Do With Your Tax Refund)

Loss Aversion

This cognitive bias describes people's tendency to strongly prefer avoiding losses over acquiring gains. Loss aversion is a nearly universal behavioral quirk that explains why so many investors hold onto tanking stocks, why would-be exercisers continue sending money each month to a gym they never visit, and why you probably still have a bread machine collecting dust in your basement. We all hate to feel as though we are losing money on something that we have already paid for.

In terms of taxes, the idea of potentially owing the IRS more money come April 15 is off-putting enough to keep many taxpayers from reducing their refunds. Losing money each paycheck to taxes is a given, but the idea of having to write a check to the IRS triggers loss aversion in many taxpayers. They would rather give up the money temporarily throughout the year and overpay Uncle Sam than face the prospect of having to give up "real" money if they get their accounting wrong.

If the thought of having to pay more in taxes than you had withheld from your paychecks puts you in a cold sweat, then aiming for a large refund might be the best option for you. Yes, your money could potentially be doing more for you in your pocket, but what good is maximizing your finances if you sweat bullets thinking about tax time?

The Money Illusion

This term was popularized by the famous economist John Maynard Keynes, and it describes our inability to recognize that a dollar amount is only as good as its purchasing power. Keynes used the term to describe the phenomenon of feeling richer when you receive a raise, even though costs have also risen; meaning you are earning the exact same purchasing power you did before the raise.

When it comes to taxes, the money illusion means that for some people, having a $3,000 refund check burning a hole in their pocket could lead them to make poor financial choices because of the sheer size of the refund.

For instance, if you are feeling flush, you may find yourself spending with impunity in every area of your life, from the expensive chocolate you rarely indulge in, to new shoes that you don't really need. But unless you are keeping careful track of each expenditure (which is the opposite of "spending with impunity"), you will likely reach the end of your big refund amount and keep on spending because you are focused on the dollar amount rather than what it buys. Your mental accounting of your refund money has trouble keeping up with your actual spending.

If you have a tendency to burn through money quickly when you have a big windfall, then it's probably a good idea to aim for a modest tax return — and set up a direct deposit of the saved money into an investment, retirement, or savings account. That way, you can make the intelligent decisions about your money before you are faced with an amount that will trigger the money illusion.

Don't Discount Your Money Psychology

We tend to think of money as a purely rational issue, but it's foolish to ignore the fact that how you feel about money will influence your financial decisions, for better or worse. In a purely rational world, receiving a large refund check every April does not make any sense. But depending on your personal money makeup, you might find that a large refund is your ideal, or you might find that keeping more of your cash in each paycheck works best for you.

The important thing is to be mindful when you make decisions about money, and to take your psychology and your strengths and weaknesses into account. Know yourself, and your finances will thank you.

Are you getting a big refund? Why or why not?

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Guest's picture
Nancy

We always (for 35 years) have tried hard to break even with the IRS--no refund, no additional payment. That's tough for us because a high percentage of our income fluctuates month to month. If we miss the target, we prefer to owe a bit more. In years past, when interest rates were high, it seemed foolish to lend the government money for free when it could get 5, 7, 10 percent saved elsewhere. However, now that savings interest rates, even for CDs and money market funds, are sub 1%, I figure it doesn't make much difference. So if a big tax refund check serves as savings account for a vacation or a new car or an amount to put in an IRA, go for it.

Guest's picture
Jeo

I've never gotten a large refund because I learned early on that the W4 tax form and exemption charts favor the government.

Everyone should do their best to adjust exemptions on their W4 so that the proper amount of tax is deducted to minimize any potential refund. Indeed, I always like to own a small amount.

The government does a horrible job at their own accounting, spends way more than they should, and wastes billions and billions of dollars each and every year. It's inexcusable and allowing them the use of your own money throughout the year free of charge is unacceptable.

There should be a basic high school class that covers this so that we are taught how this works. But then, what incentive is there to do that?