For many Americans, it's become an annual rite of spring: waiting with anticipation for that tax refund check to arrive in your mailbox or bank account.
Last year, the Internal Revenue Service issued more than 94.8 million refunds worth almost $255 billion. The agency is on track to send out a similar amount in refunds this year. And if historical trends are any indication, the IRS will do the same next year as well.
"As long as I can remember, it's been true that a very large majority of taxpayers overpay and get refunds, averaging thousands of dollars," said economist Richard Thaler, an economics professor at the University of Chicago and author of the upcoming "Misbehaving: The Making of Behavioral Economics."
But that doesn't mean it's a good idea.
"There's this perception that getting a tax refund is in your best interest because it's like found money, but why give the federal government a zero percent-interest loan with your money?" said Andrew W. Ferraro, a certified financial planner with Strategic Wealth Partners in Columbus, Ohio. "It's a missed opportunity for something better."
As of April 3, the average tax refund issued by the IRS this season was nearly $3,000. Had a taxpayer put that money into a savings or investment account instead of overpaying, advisors point out, they could have earned money on it throughout the year.
The S&P 500 and were up more than 11 percent last year. Had taxpayers put $3,000 into a passive fund mirroring one of those indexes, they could have hypothetically earned returns of more than $300 (though they'd be contributing throughout the year, not one lump sum in January, so returns will be vary).
Of course, with interest rates so low, the yield on a savings account is much smaller—even high-interest accounts are only yielding 1 to 1.1 percent. That might not be enough of an inducement to prompt taxpayers to adjust their withholding and set up transfers to their savings account. But if the Federal Reserve raises rates later this year as expected, interest on savings accounts should rise as well.
Taxpayers who get all their income from wages and salaries, and whose situation hasn't changed much since the year before, should have little uncertainty about the taxes they'll owe at the end of the year. If they've been getting a $3,000 refund each year, they probably know they could reduce their withholding at little or no risk and deposit the extra amount in savings from each paycheck. So why don't more Americans take such steps?
It's a question that's confounded advisors and economists alike.
"It's a really curious thing, and I don't think we have a really clear answer research-wise," said certified financial planner Brad Klontz, co-founder of the Financial Psychology Institute and a partner in Occidental Asset Management. "It's self-destructive in one sense. On the other hand, if they don't trust themselves to save the money, it probably is one of the smarter things that they can do."
Given the abundance of research showing how little most Americans have saved for both short-term and long-term needs, those concerns may be well-founded. One recent survey found that more than 60 percent of Americans do not have enough rainy day funds set aside to cover even a $500 car repair. And a report out Thursday revealed even among households with incomes of $75,000 or more, roughly a third live paycheck to paycheck at least some of the time, and one-fourth of those with incomes of $100,000 or more do the same.
"I've seen that some people tend to consider overpaying in taxes as a sort of forced savings plan—like the old Christmas savings accounts people would set up every year, make monthly deposits to, and then withdraw the money in time to buy presents," said Bryce Pease, a certified financial planner at Capstone Pacific Investment Strategies in Covina, California. "Perhaps old habits die hard."
Behavioral economists also cite loss aversion as a factor. Essentially, the pain of getting a tax bill for hundreds or thousands of dollars is so great that most people would prefer to overpay throughout the year to make sure they won't end up in the red. For full-time workers, the fact that taxes are taken out before paychecks are sent out or deposited helps to minimize the feeling of loss. The big refund check, on the other hand, can feel like a reward or bonus, reinforcing the cycle.
"It's a brilliant strategy on the part of the IRS," said Klontz.
There are some benefits to getting a big refund, however—depending on how you use it. While the best scenario is to put money away all year, advisors say a large refund can help to kick-start savings or make a significant dent in debt payments.
"There is nothing like a little momentum when it comes to saving for your financial goals or paying down debt," said Jon Teran, a certified financial planner at Capstone Pacific Investment Strategies. "Using your tax refund wisely and directing it toward your financial goals might give you a little boost that can go a long ways psychologically, if not financially."