My Tax Return Savings Account

It is interesting how the circumstances one finds oneself in can dramatically change their opinion of something.  For instance, 15 years ago, I was adamantly against tax refunds.  Not getting your money back, just the concept that people wouldn't pay enough attention to their finances such that they would receive thousands of dollars as a overpayment (or more likely an overwithholding) of taxes.  At the time it was obvious to me that it was much more profitable to scrutinize and adjust your withholding on a regular basis (every couple of months) so that at the end of the year you were as close to breaking even as possible.  I could put this money to work for me by investing it or at the very least put it in a savings account earning interest (as opposed to the interest free loan I would have been giving the government). I was pretty good at it for a few years, netting myself refunds of a couple hundred dollars or having to write a check for a couple of hundred dollars.

Then times changed.  I started making more money and my taxes became more complicated.  Now, at first glance one would think that making more money would be an incentive to implement my strategy above even more so.  Afterall, 15 years ago, I was only making about $25K a year.  My opinion on this issue has changed 180 degrees. Now, I would laugh in your face if you suggested the strategy above.

There are several factors that go into this.  While there is some profit to be made from investment, it doesn't come without it's own cost, namely the time necessary to adjust your withholding (or in the case of quarterly tax filers, the amount of time - ergo rigor - into estimating the taxes owed).  Couple this with exceedingly low interest rates and put a dollop of the ever changing tax code as politicians try to curry favor with this group or that group each year and you are left with a much more complicated task - so the rewards better be worth it.

In 2004 and 2005 I started a different job that had a significant amount of money made from bonuses and overtime.  Because of tax law, this income was withheld at a higher rate (remember withholding, tax owed, and tax paid are completely separate concepts and not necessarily related).  So, while my base pay was withheld at the legal minimum for federal income tax ($0), I was still being withheld on my bonus and overtime income.  And there was no way to not have it withheld.

My time was also more valuable, while as a college student I might jump at the chance to earn $10-$15/hour, I was making much more than that.  To put it in perspective, if my base rate was $30/hour and my boss wanted me to work overtime, he would have to compensate me for my time, usually at a rate of $45 per hour.  So, in effect my leisure time was worth $45 per hour.  On the other hand, if I wanted to make more money, I had to go and find that work and I might only be able to find something for $10-$15. 

The only "extra" work I ever did during this time was I was an usher at Texas A&M football games.  I was paid $50 per game (and I didn't have to spend $50 per ticket).  I was able to see most of the game - in particularly the 4th quarter since my shift was done at the end of the 3rd.  I did have to show up a couple of hours before the game, and the game was 3 hours, so figure about 5 hours total.  For $50-$100 of value (since I would have bought tickets to go to the game anyway).  And the first couple of hours, I brought a book or headphones to do what I normally would be doing at home.  This was a great gig.  To bad I didn't find out about it until my senior year.

So, only on rare occasions have I been willing to trade my leisure time for less than $25/hr.  When faced with a job that was out to defeat my tax philosophy, I decided to evaluate and determine if it was worth it to find some way around it.  Turns out, in my situation (and the vast majority of Americans situations), it's not worth it.

Let me illustrate.  For the last 8 years, I have been getting tax refunds of $3000-$7000.  Well above the national average of $2000 to $3000.  The question one has to ask is what would you do with the money if instead of getting it in one big lump sum, you got a little bit more in every paycheck?  Investing in the stock market historically has been the best performer.  I assumed that I get a refund of $5200 each year (it makes it easily divisible by 26 paychecks a year).  So each paycheck I would have a theoretical $200 to invest in the stock market (I'll use SPY the S&P 500 ETF).

	Value	$ Increase	% Increase	$/hr
2005 S&P	$5,355	$155	3.0%	$15.50
2006 S&P	$5,613	$413	7.9%	$41.29
2007 S&P	$5,177	($22)	-0.4%	($2.26)
2008 S&P	$3,814	($1,386)	-26.7%	($138.61)
2009 S&P	$6,265	$1,065	20.5%	$106.50
2010 S&P	$5,729	$529	10.2%	$52.85
2011 S&P	$5,184	($16)	-0.3%	($1.61)
2012 S&P	$5,375	$175	3.4%	$17.46
2005-2012 S&P	$42,511	$911	2.2%	$11.39

Basically, at the end of the year, hopefully you have more money than you put in.  Now, in order to game the tax withholding every couple of months you are going to need to go through and project what your tax return is going to look like at the end of the year (taking into account the money you have not yet made and the changes that the politicians have not yet proposed). Then you can adjust your withholding allowances/exemptions to change the amount that is withheld. Bear in mind that you probably want to err on the side of caution because while there is no bonus for having too much withheld, there are penalties for not having enough withheld.  So, I conservatively assumed 10 hours per year spent analyzing and adjusting your tax withholding to calculate how much per hour this is equal to.

You can see from the list above, there are only three of the eight years in which crunching numbers for 10 hours a year would exceed my $25 free time price.  Yours may be lower, but there were still three of eight years when the ROI was negative, so no amount of tinkering would have made it worth your time. Overall, $11.39/hour average doesn't sound too shabby - but remember, I make enough money to have $5200 refund each year, if you are only getting the national average of $2600, then cut this $11.39/hr in half and you have something that is less than minimum wage - in other words it would be more profitable for you to just go out and get a job at McDonalds for two days (five hour shifts) each year and then quit rather than try to monkey around with your tax withholding throughout the year.

But the 2005-2012 S&P line can be misleading.  This is calculated by just adding up each of the yearly amounts.  I did this since we plan our tax refund into our budget and mainly have it targeted to pay for big ticket items (replacing roof, buying car, etc.) that we know are happening in the next year.  What about if you plan on saving this for the long term, there could be a lot of good benefits, right?

	Value	$ Increase	% Increase	$/hr
2005-2012 S&P Yearly	$42,511	$911	2.2%	$11.39
2005-2012 S&P Combined	$48,765	$7,165	17.2%	$89.56

Well, the Combined column (assumes you don't spend it each year) is starting to look really good.  $89/hr is a heck of a lot more than I make.  Obviously, if the S&P 500 does average or even good in 2013, then this doesn't change the rosiness of this picture.  But what if instead 2013 becomes another 2008?

	Value	$ Increase	% Increase	$/hr
2005-2012 S&P Yearly	$42,511	$911	2.2%	$11.39
2005-2012 S&P Combined	$48,765	$7,165	17.2%	$89.56
One More Bad Year	$46,325	($475)	-1.0%	($5.27)
One More Bad Year Combined	$33,580	($13,220)	-28.3%	($146.89)

So, I calculated for one more bad year, assuming that you spend it every year and it is bad, but if you were using it as long term savings, then that $89/hr turns into -$146/hr.  In one year, of course the next year may be better than before. Or it could be worse.  You don't really know, so, I would suggest not using this as the basis to make a decision.  Don't get me wrong, I invest in the stock market and encourage others to as well. Its just not a place to put money that you may need in the short term.

So, let me look at something that is more stable, like bank interest rates.  I can count on this to always be positive. 

	Value	$ Increase	% Increase	$/hr
1% Savings	$5,227	$27	0.5%	$2.71
2% Savings	$5,254	$54	1.0%	$5.43
3% Savings	$5,282	$82	1.6%	$8.18
4% Savings	$5,309	$109	2.1%	$10.94
5% Savings	$5,337	$137	2.6%	$13.72

Nope, this certainly doesn't change things.  Unless interest rates are astronomically high, there is no sense in me using my leisure time to play with taxes.  In fact with some of these, I know my daughter has made more operating a lemonade stand.

So, for the last 8 years, my opinion has changed.  At one point in my life the $25 extra a year in interest I might have made sense, but I had a whole lot of extra time back then. Yes, I have been giving the government an interest free loan for thousands of dollars, but on the flip side, the actions I would need to take to not give them that loan are not worth it.  If there was no penalty for underpayment, then I wouldn't because it would make the decision easy (arrange to have nothing withheld and just write a check on April 15th).