MANY EMPLOYEES deliberately have too much income tax withheld from their paycheck, so they receive a fat refund each spring. Federal refunds averaged $2,850 per income-tax return in 2014, the latest year for which data is available.
This is completely irrational and entirely sensible.
It’s irrational, because we’re making an interest-free loan to Uncle Sam. Why not have the correct amount of tax withheld, and then take a sliver of each paycheck and pop it in a high-yield savings account, so we’re the ones earning interest?
We, of course, already know the answer: If the money was in our regular paycheck, we’d likely spend it. But if we get a lump sum as a tax refund, the money will seem more significant. Instead of frittering it away, we might save the money or use it to pay down debt. Homo economicus may always behave rationally, but we humans need a little trickery if we’re going to spend less today and save more for tomorrow.
In addition to tax refunds, we might receive other windfalls, such as a year-end bonus, an inheritance, and income from freelance work or a second job. There might also be smaller sums, such as reimbursement from our employer for travel expenses or the cash back we’ve accumulated by using a rewards credit card. In each case, these sums aren’t part of our regular income, so they can be a painless source of extra savings.
Over the years, my own nest egg has received a big boost from such windfalls, including advances for various books I’ve written and the year-end bonuses I received when I worked at Citigroup. Each time, I used the money for a special purpose, such as building up my mutual fund accounts, paying off a chunk of my mortgage or funding home remodeling projects. Admittedly, the latter shouldn’t be considered an investment (or, if they are, they aren’t good ones). But in each instance, I never simply spent the money, with nothing to show for it.