Thursday, December 17, 2015

"Tax-Refund" Should Be A Dirty Word

It's almost time to mark an "X" through December 25th on our calendars. After that, the next big date on the calendar for most of us is April 15, 2016 - the tax filing deadline. The excerpt below (from a 2012 article on financial has some advice about tax refunds. See what you think:


"The average tax refund is around $3,000 in America according to the IRS. Since saving, or not spending $250 a month is difficult for many, I’m OK with such a refund. With basic savings interest rates close to zero, your opportunity cost is pretty small. If we are to compare the average tax refund to the average per capita income in America of $50,000 (~$40,000 tax), $3,000, or roughly 6-7% of income is a pretty meaningful number.... There’s a big debate on whether you should have a tax refund at all, given that simply means you overpaid our incredibly inefficient and wasteful government. Since most people can’t save for cookies, I’m of the opinion that a tax refund is good for most people. Even if you did have that $3,000 in your bank at the beginning of the year, your savings interest rate will be less than 0.5% as of 1/15/2012, which is a small opportunity cost..." 


Now before you dismiss the article and the advice as dated, consider that the interest rates being paid today on regular savings accounts are .01% (one basis point away from zero) and the average refund is still around $3000.

So the author's advice would seem even more sage and relevant today right?

Not so fast.

There is a bigger opportunity cost than .01% to consider since "refund guy" could have chosen to regularly invest $250 chunks of that money in stock over 12 months rather than putting the same increments into a savings account earning virtually nothing over the same period of time. That regular investing of a set amount, regardless of stock price, is the essence of dollar cost averaging, which has been spoken of often on this blog. But let's take some real numbers and drive home the point to "refund guy" that the opportunity cost to him would be much more significant than he's been lead to believe. See the tables below with actual information about GE's stock price from January of 2014 through April of 2015:

If "refund guy" had filled out his form W-4 such that the $3000 he loaned to the government, interest free, would have been available to him in monthly $250 chunks, he would have been able to purchase 115 shares of GE stock at an average price of $25.93, thereby transforming himself into "dollar cost averaging guy".

Since his withholding was still set properly, he would have continued his purchases into 2015, through the tax filing deadline.  

If refund guy had taken the author's advice and kept his withholding high, he'd have nothing to show for it but the $3000 refund he'd get by the end of April (if he E-filed).   But even if he found religion at the end of April and decided to buy GE stock with his windfall, he'd still come out way behind "dollar cost averaging guy" since:

 - he'd have paid more per share
 - he'd own fewer shares
 - he'd have been $1200 behind in total portfolio value

So the opportunity cost is much more than .01% in the short term.  But if we throw in the compounding of each of those dollars and the ones that would be added over the next twenty or thirty years, the gap would become obscene. 

Time to go see HR.


No comments:

Post a Comment